Danske Bank

Denmark’s largest bank has been the subject of much discussion in the past year, as it was at the centre of a major money laundering scandal. In the shadow of this scandal, however, Danske Bank is at its core becoming gradually healthier and more focused.

Danske Bank is Denmark’s largest bank, mainly operating on the Scandinavian markets. Since the financial crisis, the bank’s activities have become increasingly focused on the “domestic markets” in Denmark, Norway, Sweden and Finland referred to as “Banking Denmark” and “Banking Nordic.”

This focus contrasts with earlier management teams’ focus on international expansion via acquisitions made before the global financial crisis, involving both the acquisition of an Irish bank in 2004 and, not to forget, the expensive acquisition of Sampo Bank in 2006. In the case of Sampo Bank, it was not just an expensive acquisition, it also came with the acquisition of the much-discussed branch in Estonia. Both acquisitions had a severely negative consequences for the bank’s shareholders, and the acquisitions in Ireland were close to bringing down the bank in 2008 and the start of 2009, resulting in the Danish Government having to step in with several rescue programmes.

Generally speaking, we believe that the most value-creating banks are the most focused ones, especially the ones focused on retail and small commercial customers. There is less financial risk associated with these customer segments due to the size of the individual engagements compared to the large commercial customers. Focusing on a smaller number of markets is also positive for a bank’s economies of scale on these markets and their ability to evaluate the quality of assets that can be provided as collateral by the individual customers. Danske Bank uses the same platform in all the Nordic countries, and this is a positive factor in being able to take advantage of the economies of scale that should derive from being a large company.

The focus on the Nordic markets therefore helps to reduce the risks that the company faces, even if the credit and liquidity risks in a bank will always be the main risk factor.

Danske Bank has a new management team, and we expect that this new management under a new chairmanship will work together in changing the corporate culture back towards the “old” Danske Bank set of values that are focused on integrity, as well as a strong cost and credit culture. The increased focusing of Danske Bank is not a new initiative but has gradually taken place over the last decade – and Danske Bank has not carried out speculative positions on its own book since 2014.

In 2017, Danske Bank was put under the spotlight as a result of its involvement in money laundering in its Estonian branch. The extent of this turned out to be surprisingly comprehensive as studies by the bank showed during 2018, and the share price took a dive over the course of the year as a result. Subsequently, we became co-owners of the bank during the autumn.

We haven’t previously owned shares in Danske Bank. The changes in the management team and the focusing of the business since the financial crisis are currently still overshadowed by this massive corporate scandal, but the bank is otherwise in a better state that it has been for a long time, with increased operational predictability, a greater focus on its primary markets and a stronger balance sheet.

Would you be able to live with your family reading about it in the newspaper?

The problems in Estonia are not considered to be an expression of the bank’s entire culture, but we are disappointed that it took so long to raise questions about the dubious activities taking place in Estonia, where earnings were from highly profitable – but questionable – activities with extremely high returns on capital. Fundamentally, we find that a good management team should be capable of rejecting questionable business activities regardless of how tempting and profitable they might be. Danske Bank, alongside several other Nordic banks operating in Estonia, seem to have underestimated the country’s historical ties to regimes with different core values than those the Scandinavian banks encounter on their domestic markets.

In this context, Warren Buffett has a good rule of thumb for whether it should be decided to move forward on a decision or not: if an article appeared in a local newspaper about a decision and action you made, and your family and friends read the article, would you feel good about it? It sounds simple, and it probably is. Several of the bank scandals in recent times might have been avoided if this kind of thinking had been used. However, it is therefore also positive that several Nordic banks have realised the importance of something as basic and old fashioned, as acting in a decent manner.

On the micro scale, banking is a quite simple concept. A customer borrows a sum of money and then the bank charges an interest rate that is higher than the rate the bank’s funding costs. This difference is called the net interest margin.

Thus, it is critical that loans only be provided to customers with the ability and the will to repay them.

Generally, when we talk of the balance sheets of banks as being hard to decipher, it is because this simple loan mechanism becomes much more difficult to understand when we are suddenly faced with hundreds of thousands of bank customers and various types of banking activities. When the scale is so great, what was easy to understand suddenly becomes significantly more difficult, if not nearly impossible, to get a full overview of. That is why people say – and why we agree – that the trust that is placed in the bank is of critical importance.

It is critical that a bank can access capital from both its depositors and via financing through the capital markets. If there are doubts about the bank’s ability to continue to operate or secure future capital requirements, the price it needs to pay for this funding increases, and in the worst-case scenario, depositors will quickly withdraw their money hoping to beat the panic – a so-called “run on the bank”. A bank cannot survive without access to funding.

Uncertainties concerning future capital requirements can also result in the bank’s counterparties demanding higher funding costs, reducing the net interest margin of a bank and thus its ability to generate earnings. Currently, Danske Bank’s financing costs are negatively impacted by the Estonian scandal and to a great extent the uncertainty surrounding the amount of a likely financial penalty and potential commercial consequences. It is our assessment that the increased funding costs will be transitory.

Today, Danske Bank faces a major task in restoring trust among customers, society and investors, and it also needs to make more investments in its control mechanisms and ensuring that the right processes are in place to prevent something like this from happening again. It is positive that Danske Bank has been able to retain more than 99 percent of its customers and that it was capable of increasing its lending by more than three percent in 2018, during a time when several Danish banks were struggling just to maintain their level of lending.

Retail customers are stable and profitable

Two out of three Danish kroner in pre-tax earnings come from the bank’s main areas – retail banking in Denmark and the Nordic. Providing banking services to retail customers and small businesses is a stable business area with generally long customer relationships, and the risks associated with the individual commitments are not significant in terms of potential impact on the bank’s capital base. The return on allocated capital is also around 20 percent within these areas, and together with asset management, these are the highest among the bank’s business areas.

It is important to keep in mind that it is extremely uncommon for banking activities related to retail customers resulting in a bank going under – it is the large commercial loans, the bank’s own speculation or mismatches in the bank’s financing that leads to banks failing.

The lending in Banking Danmark and Nordic grew in the past year by, respectively, one and five percent in kroner (while keeping costs tightly under control), and both divisions had fewer full-time employees at the end of the year than they had entering the year. We see good opportunities for technology and software being used to streamline the bank’s operations. Compared to the development in earnings in the two areas, costs were also kept at a stable level amounting to just under half of income, and this is better than what most other large Nordic banks manage.

Approximately 16 percent of earnings in 2018 came from Corporate & Institutions, and this is an area where customers have a hard time getting around Danske Bank in Denmark. Corporate & Institutions provide major commercial loans and services related to the customers’ capital market needs. Due to its size, Danske Bank certainly has a competitive advantage in several of these areas, but in our view, this business area does not have the same attractive stability due to factors such as it being a more competitive business environment. This results in it being more difficult to create a long-lasting and attractive relationship between generating returns on capital and business risks, compared to the private banking area.

Declining levels of investment

Historically, Danske Bank has been disciplined in controlling costs – and, during periods when this has been an area of focus, the bank has delivered on the savings they said they would make. By and large, Danish banks have a healthier level of costs than many other European banks (taken as a whole), and Danske Bank is near the top of the list among large Danish banks in this regard. We expect that management will maintain and improve this level.

The money-laundering case also resulted in major growth in investments in so-called AML (anti-money laundering) processes. In 2018 and 2019 alone, the bank expects that an additional 900 people will be hired in the department managing regulatory controls, and this will have a negative impact on the bank’s cost-to-income ratio. At the same time, there will be significant costs involved in investigating the case, including the costs incurred in connection with having a law firm do the initial investigation that resulted in the exposure of a mind-boggling 200 billion euro in suspicious bank transfers. In 2018, costs reached 25 billion kroner, and this is also expected to be the level of costs for 2019, which is an increase in costs of around one and a half billion kroner compared to previous years. In that context, management indicates that the bank will find savings to fund the increased investments in processes and IT.

Despite these issues, in addition to a number of extraordinary costs, low deposit margins and a relatively low contribution to earnings from Corporate & Institutions, Danske Bank managed to attain a return on equity of ten percent. In the long run, this is not a satisfactory level, but we do not expect that the bank will continue to maintain such high cost levels once the current investments in IT and processes have been implemented and they begin to streamline the bank’s operations in a safe manner. From a cost perspective, 2019 is expected to be the toughest year in this investment phase.

Previously, the bank has had a target for return on equity to be between 12 to 13 percent, but management has kept its target of having a “top three” return among the large Nordic banks. The previous target of having a much higher level of return should still be possible to achieve once the current investment phase winds down. In the future, the level of regulatory compliance hirings, which have been growing at the fastest pace in terms of new employees, are expected to subdue. It is praiseworthy that management has responded and invested significantly in this area.

Lower credit ratings have been costly

At the start of 2018, Danske Bank announced that it would buy back shares equivalent to ten billion kroner during the course of the year, and at the time, this amounted to approximately five percent of the market value. This share buyback programme was, however, cancelled in the autumn after having purchased seven billion kroner worth of shares – and this was perfectly reasonable. We agree with management’s choice to stop the share buyback programme and instead strengthen the bank’s capital base. Fortunately, though, management decided to keep the dividend of 8.5 kroner per share, equivalent to seven percent of market value, which was in line with the dividend policy stating that they will pay out half of the year’s profits.

Strengthening the capital base is a sensible move, as the money laundering case has resulted in uncertainty surrounding the bank and thus higher costs in securing the funding that the bank obtains through the capital markets – for example, as it issues subordinate loan capital etc. Here the bank saw increasing interest rate spreads in the autumn, in part due to downgrades in its credit rating from “the big three” – Moody’s, S&P Global and Fitch – and with the outlook remaining “negative”. It is assessed that the financing costs in the capital markets should normalise from their current levels once there is more clarity on the financial consequences of the Estonian case and as the bank strengthens its regulatory capital base. This will be be positive for the bank’s net interest margin and thus, its earnings.

Danske Bank’s total risk-weighted assets have been reduced significantly after they peaked following the global financial crisis in 2014 at 865 billion kroner.
At the end of 2018, this had been reduced to 748 billion, though this is still somewhere near a third of Denmark’s GDP. Over the years, management has (among other things) limited how much “speculative” capital market exposure the bank is allowed to keep on its own books, where it is shareholder capital that acts as a cushion in the event of negative developments in this exposure.

While the risk-weighted exposure has been reduced, the size of the bank’s core equityremains relatively unchanged in this period. The core tier-1 ratio has thus reached a level of 17 percent of the risk-weighted assets, and this is expected to increase in 2019 to around 19 percent, as only half of the 2018 profits will be distributed to shareholders. In addition, it is worth noting that low growth in the risk-weighted assets is expected in the coming years. The regulatory capital should be sufficient to both pay a potential fine and maintain sufficient buffers to weather a slowdown in economic growth sheet to pay both a fine and weather a slowdown in economic growth.

The authorities continue to investigate the money laundering case, and the investigation is not expected to end in 2019. It is likely that Danske Bank will be fined, but we do not expect the bank’s business opportunities to be restricted. There is no record of systemically important financial institutions receiving receiving fines that might be destabilising to the system.

The greatest uncertainty in terms of the fine is what the authorities in the United States will do. The United States’ Department of Justice and the Securities and Exchange Commission, SEC, is still in the preliminary stages of investigating the bank, and on that note, it is also worth keeping in mind that Danske Bank does not have, and has never had, a banking licence in the United States. Thus, all dollar exchanges have been via custodian banks, and there is therefore no risk of losing a US banking licence.

The share price development and valuation of the bank on the stock market seem to reflect significantly larger fines expected than we think are likely to materialise. The price of Danske Bank today only represents 0.7 times the bank’s book value and around 7 times expected 2019 earnings that management expects to amount to approximately 15 billion kroner after tax – which is weighed down by significantly higher costs and investments, low expectations for the Corporate & Institutions division and ongoing low deposit margins.