Pillar II

Pillar I contains uniform rules for capturing the risk of an average financial institution. It is important to note that the risk profiles of today's financial institutions are very diverse, and that no set of uniform rules can capture all these diversities. Pillar II is an attempt to meet this challenge. Pillar II specifies the framework for the supervisory review process and sets a framework for further capital requirements based on the situation and characteristics of the individual institution. Pillar II also encompasses risk not defined under Pillar I (i.e. concentration and residual risk) as well as stress testing.

One of the most important objectives of Pillar II is to encourage banks to set internal capital targets which are in line with the individual bank's operations and risk exposure. Pillar II builds on four fundamental principles:

• Internal processes
  Banks should create an internal process for evaluating their own capital adequacy in relation to their specific risk profile. This process is usually referred to as the ICAAP (Internal Capital Adequacy Assessment Process).
  
  
• Evaluation of internal processes
  The regulator should evaluate banks' internal capital adequacy assessments and strategies. The review process could involve discussions with the management, periodic reporting and on-site inspections.
  
  
• Capital in excess of the minimum
  Regulators can demand banks to hold capital in excess of the minimum required amount.
  
  
• Early intervention
  Regulators should try to intervene as early as possible in order to prevent capital from falling below the stated minimum capital level. Regulators should also have the authority to require changes to a bank's risk management procedures and systems.

Home-Host issues
The supervisory review process should be coordinated across borders in order to manage the regulatory burden for multinational banks. The cooperative framework can be summarised as follows:

• The consolidating regulator is responsible for the review process for the whole group. This includes the responsibility for assessing the internal governance and the ICAAP at group level.
  
• The host regulator is responsible for the review process at local level. This involves assessing the internal governance and the ICAAP at subsidiary level.
  
• The degree of integration of a group and its internal organisation is important in the review process. Multinational banks often centralise functions like risk management. This will require coordination between home-host regulators, and the consolidating regulator will be a key player in this coordination.
  
• The consolidating regulator may allocate some tasks to a host regulator. The host regulator may do the same and it may also delegate full supervision to the consolidating regulator.

ICAAP (Internal Capital Adequacy Assessment Process)
The ICAAP ensures that management

• adequately identifies and measures the bank's risks
  
• maintains adequate internal capital in relation to the bank's risk profile
  
• uses sound risk management systems and develops them further

The CRD states that banks should "own", develop and manage their ICAAP. The regulators should not dictate the use of the process. Instead they should review and evaluate both the ICAAP and the soundness of the internal governance processes in which the ICAAP is embedded.

Stress tests

Stress tests are important tools for analysing a bank’s risk profile. Stress tests identify the central risk drivers and analyse the effect of significant negative shocks to these risk drivers. The effects can be measured in income statement, balance sheet and solvency terms.

Danske Bank has conducted a number of Groupwide stress tests at regular intervals since 2005 at regular intervals. The stress tests show how the Group would fare if it suffers various economic shocks over a period of three to five years.

Stress testing is basically rooted in the same concepts as economic capital and risk-adjusted income, but it operates with a longer time horizon and is based on sudden and drastic macroeconomic events. Its calculations also take account of a larger number of factors, including concentration and migration risk as well as diversification impact under credit risks.

Economic capital is calibrated according to Danske Bank's models at a confidence level of 99.97%. The purpose of stress testing is to evaluate the impact of possible unfavourable events on the Danske Bank Group’s earnings and solvency. As a supplement to the calculation of economic capital, stress tests indicate how Danske Bank's capital base would be affected in scenarios in which the estimated risk parameters are not complied with.

In recent years, Danske Bank has applied stress testing as an internal method and process, and Danske Bank's approach to stress testing will continue to develop. At present, Danske Bank has had introductory and general discussions with the Danish FSA on how stress testing can be included in the future assessment of the Group’s capital level. So far, Danske Bank has discussed methods and processes with several international banks that have made considerable progress in this area and has adapted its approach to the recommendations made by the UK FSA.

Stress testing is an analytical process, for which one or more macroeconomic scenarios are selected as the basis of stress test calculations. Testing is based on sudden and drastic macroeconomic events, such as a plunge in the value of the US dollar, an oil price shock, a general recession, etc. The Group applies the following nine scenarios: 

Scenario	Brief description
Recession (1 in 25) Period covered: 3 years Macro, worst year: GDP -2.1% Unemployment 9.9% Property prices -14.2%	Sharp fall in exports and rising taxes lead to decline in demand
Deflation Period covered: 5 years Macro, worst year: GDP -1.0% Unemployment 15.2% Property prices -8.0%	Structural problems in Europe lead to recession and deflation
Falling property prices Period covered: 5 years Macro, worst year: GDP 0.4% Unemployment 9.4% Property prices -12.2%	Rising interest rates lead to a fall in housing prices
Mild recession Period covered: 3 years Macro, worst year: GDP 1.4% Unemployment 6.4% Property prices 0.7%	Zero growth two quarters in a row
Oil price hike Period covered: 3 years Macro, worst year: GDP 2.1% Unemployment 5.6% Property prices -1.1%	Sharp increase in oil and commodity prices leads to lower purchasing power (consumers and companies)
Fall in US dollar Period covered: 3 years Macro, worst year: GDP 2.0% Unemployment 5.9% Property prices 0.9%	Deficit in the US trade balance leads to a global recession
Liquidity crisis, sector	Liquidity crisis which leads to credit losses and a negative effect on funding
Liquidity crisis, Danske Bank	Default by one of Danske Bank's largest customers and a downgrade on Danske Bank's rating
Epidemic	14,000 die, including 4,000 employed

 Until further notice, the Bank will not include ‘management intervention’ or ‘intra-risk diversification’ in these calculations. That enables a conservative interpretation of how a given macroeconomic scenario would impact the Group.
The scenarios and the macro economic inputs are updated regularly.

There are four general steps in Danske Bank's stress testing methodology:

I. Choice
The scenarios are defined by the Group’s Board of Directors and the scenarios and the macroeconomic input are updated regularly.

Each scenario covers a three-to-five-year period, and the Bank regularly assesses for each year the estimated impact of various economic shocks on macroeconomic key indicators. A period of from three to five years is applied to enable evaluation during a full economic cycle.

The scenarios cover both earnings and risk. The Bank has developed translation models to indicate the effect on the Group’s risk parameters in each year of each scenario.

II. Translation
The next step is to translate the events into macroeconomic variables.

Translation is prepared using the OECD’s macroeconomic Interlink model and historical correlation during previous economic shocks, such as an oil crisis. The OECD Interlink model describes how macroeconomic variables, such as GDP growth, industrial production, consumer spending, inflation and unemployment rates, develop in relation to a macroeconomic event.

In addition to the international models, the Group also applies internal models based on estimated relations between the macroeconomic variables, Danske Bank's historical observations and other factors. The models also consider the correlation between economic developments and customer drawings on credit facilities. For example, this could be a calculation of the impact on the probability of default (PD), the impact on deposit and lending growth and the interest rate margin. The PD model is based partly on Danske Bank’s industry-specific loss frequencies since 1991 and the correlation with GDP, unemployment, etc.

III. Calculation
After the stress parameters have been found, the Group’s current risk portfolio is used to estimate the impact on profit after tax, risk-weighted assets, the loss account and changes in Group capital, taking account of the dividend policy.

Earnings are projected using value drivers such as, when estimating interest income, the interest margin on deposits and loans and advances and the volume of deposits and loans and advances.

The calculations include, among other things, the effect that the value of collateral will fall in most unfavourable scenarios. The individual stress effects are calculated for each of the years of the 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 is rarely in the first year.

For the credit risk component, the calculations include the expected loss and the impact on Danske Bank's internal risk statement, economic capital. Risk-weighted items are calculated in accordance with the methods of the CRD on the basis of an internal rating-based method.

Risk-weighted assets will typically rise fairly much in an unfavourable scenario. The Group can thus assess the trend in solvency (according to the future rules).

IV. Assessment
The impact of the various scenarios is calculated for all relevant types of risk, in order to enable an impact assessment for all parts of the Group’s risk portfolio. When the necessary capital requirement has been assessed and determined, it forms part of an overall assessment that takes into account growth plans, strategy, etc.

The scenarios and their relevance to the Group are assessed once a year using an analysis of the risks that are most important to the Group in the current economic situation. The analysis is submitted to the All Risk Committee for approval of the scenarios as the platform for subsequent stress testing. Stress testing conclusions and the impact of scenarios on expected losses and capital requirements are subsequently submitted to the Board of Directors.

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Last updated/revised on January 31, 2008