Danske Bank A/S : Fitch Revises Outlook on Danske Bank to Stable Affirms at A

6/11/2021

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11 JUN 2021

Fitch Revises Outlook on Danske Bank to Stable; Afrms at 'A'

Fitch Ratings - Warsaw - 11 Jun 2021: Fitch Ratings has revised the Outlook on Danske Bank A/S's Long-Term Issuer Default Rating (IDR) to Stable from Negative. At the same time, Fitch has afrmed the bank's and its mortgage bank subsidiary Realkredit Danmark A/S's (Realkredit) Long-Term IDRs at 'A', Viability Ratings (VRs) at 'a' and Short-Term IDRs at 'F1'. A full list of rating actions is below.

The revision of Danske's Outlook refects our view that its asset quality and proftability are likely to remain resilient under our updated assessment of various possible downside scenarios to our baseline expectation of a steady economic recovery. We expect 3.1% GDP growth in 2021 and 3.5% in 2022 in Denmark. We expect the four Nordic governments where Danske operates to maintain sufcient fscal space to extend support to their economies in case of renewed adverse economic developments.

The Outlook revision also takes into consideration our opinion that Danske's solid capital ratios, which we expect to be maintained, provide a sizeable bufer to absorb potentially large fnes from anti-money laundering (AML) investigations.

Key Rating Drivers

DANSKE

IDRS AND VR

Danske's ratings refect the bank's strong universal banking franchise in Denmark and to a growing extent across the Nordic region, providing stable revenue generation across a wide range of products. The ratings also consider Danske's low risk appetite, stable funding and solid capital bufers built up in the expectation of possible money-laundering related fnes and operational risk.

We have revised Danske's ESG relevance score to '3' from '4' for Governance Structure because it no longer has an impact on the bank's ratings in combination with other factors. The previous score of '4' refected elevated legal risk of a large fne, which together with the economic fallout from the pandemic, drove the Negative Outlook. We no longer expect the bank to receive an AML-related fne that could bring about a downgrade of its VR. We also believe that a potential fne would not damage Danske's franchise or funding profle to an extent that would warrant negative rating action.

Danske's operating revenue has been broadly resilient, despite the cyclical challenges of margin pressure in the highly competitive Nordic markets and the economic downturn. Higher funding costs, partly due to a sustained issuance of senior non-preferred instruments, and high AML-related expenses, reduced the bank's cost-efciency and its proftability to levels below peers.

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We expect better results in 2021 (albeit still notably lower than 2019) due to positive lending momentum, materially lower credit losses and a sizeable cost reduction, in line with the bank's restructuring plan. Danske's cost optimisation eforts started having results in 2H20 as underlying expenses have begun to shrink. We expect the bank to make further progress in 2021 and 2022 towards annual operating proft/risk-weighted assets (RWAs) of about 2% in the medium term.

Danske's impaired loan ratio (Stage 3 loans/ gross Loans) remains above most Nordic banks but is in line with similarly rated international peers. We expect a moderate increase in default rates later this year, bringing the impaired loan ratio closer to 3%, due to the wind-down of government support measures. Danske's loan book exposure is dominated by low risk residential mortgage loans, commercial real estate and housing cooperatives, with a limited share of more vulnerable agriculture and industries sufering from the pandemic.

Risk-weighted capital ratios compare well with those of international peers, with a common equity Tier 1 (CET1) ratio of 18.1% at end-March 2021. Management has built bufers into its stated target for the CET1 ratio of at least 16%. In 4Q20 Danske fnalised its internal AML investigation (there were no new material issues) and the US authorities cleared it of potential sanctions breaches regarding the Estonian case. In our view, this reduces the risk that a potential capital-depleting fne will depress Danske's capital ratios to a level no longer commensurate with its 'a' VR.

The bank remains subject to criminal and regulatory investigations by the authorities in Estonia, Denmark, France and the US, relating to past AML control defciencies in the Estonian branch. We expect that the bank will maintain sufcient loss absorption capacity to cushion a sizeable potential fne from European and US authorities.

Danske is reliant on wholesale funding, like most Nordic banks. Its well-diversifed funding base has proven resilient to the negative news from the AML investigations, enabling the bank to execute its funding plan. The spread-widening on the international funding markets has increased funding costs but remains manageable.

Danske's Short-Term IDR and short-term debt rating of 'F1' are the lower of the two options mapping to a Long-Term IDR of 'A'. This refects our assessment of the bank's funding and liquidity factor at 'a+', compared with the minimum level of 'aa-' required for a Short-Term IDR of 'F1+' under our criteria.

PREFERRED DEBT, NON-PREFERRED DEBT, DERIVATIVE COUNTERPARTY RATING (DCR) AND DEPOSIT RATING

Danske's long-term senior preferred debt and deposit ratings and DCR of 'A+(dcr)' are one notch above the bank's Long-Term IDR. This refects the protection that could accrue to deposits and senior preferred debt from the bank's more junior bank resolution debt and equity bufers. At end-March 2021, this bufer was 23% of RWAs, adjusted for Realkredit, which is excluded from Danske's resolution strategy. We expect Danske's resolution debt bufer to remain comfortably above 10% in the long term. This also drives the equalisation of Danske's long-term senior non-preferred debt with the bank's Long-Term IDR.

Danske's short-term senior preferred debt and deposit ratings are mapped to their respective long-term ratings and also refect our assessment of the bank's funding and liquidity at 'a+'.

REALKREDIT

IDRS AND VR

Realkredit's ratings refect its low risk appetite and strong asset-quality metrics, which balance its monoline business model and undiversifed (albeit stable) earnings. They also consider Realkredit's well-entrenched

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mortgage lending franchise in Denmark, strong capitalisation and well-managed reliance on wholesale funding.

Realkredit's IDRs are based on its standalone fnancial strength, despite sharing some central functions and distribution channels with its parent bank, which we regard as ordinary support. Currently, Realkredit's VR is rated in line with its parent's as we believe that there is a high correlation between the two VRs because of a high level of capital fungibility. Consequently, we are likely to retain the Realkredit's VR within one notch of that of its parent, unless the fungibility of capital reduces.

Realkredit is the second-largest Danish mortgage lender with about 25% market share and as a result its assets represent the majority of Danske's mortgage loan exposure. Realkredit's loan book is geographically concentrated in one country and are thus strongly linked to the performance of the Danish economy.

Realkredit's asset quality is a rating strength underpinned by prudent underwriting standards and robust collateralisation, which limits credit losses. Asset quality in 2020 sufered only modestly due to limited direct exposure to industries that are vulnerable to the coronavirus outbreak. We expect a modest increase in the bank's impaired loan ratio to about 1.5% at end-2021 and elevated credit losses at about 5bp of gross loans as delinquencies materialise after the wind down of government support. Loan impairment charges should materially shrink in 2022, due to economic recovery and the limited risk of property prices correction.

Realkredit's proftability is weaker than similarly rated peers, as its income is almost solely reliant on its lending activity, but it has been stable and its cost efciency is robust. We expect Realkredit's operating proft/RWAs to remain in line with a 'a' category rating, but most likely to remain below 3% due to administrative margin pressure and regulatory-driven infation of RWAs.

Realkredit relies extensively on wholesale funding because mortgage lending is by law entirely funded by covered bonds in Denmark. We believe that the risk of Realkredit not being able to access the covered bond market is low, due to strong demand for these bonds from Danish fnancial institutions, insurance companies and pension funds. Refnancing risk is also mitigated by the bank's good liquidity bufer and potential ordinary support from Danske if needed.

Realkredit's strong capitalisation is underpinned by its low-risk business model and solid capital surplus over regulatory minimums, giving the bank sufcient cushion to absorb potential credit losses and infation of RWAs. Realkredit's CET1 ratio of 27.9% at end-March 2021 is boosted by relatively low risk-weights on mortgage loans, but leverage is adequate in a European context. As a mortgage bank, Realkredit is subject to standalone capital requirements, which underpins our view of the bank's capitalisation.

Realkredit's Short-Term IDR and short-term debt rating of 'F1' are the lower of the two options mapping to a Long-Term IDR of 'A'. This refects our assessment of the bank's funding and liquidity factor at 'a', compared with the minimum level of 'aa-' required for a Short-Term IDR of 'F1+' under our criteria.

SUPPORT RATINGS AND SUPPORT RATING FLOOR

Danske's Support Rating (SR) of '5' and Support Rating Floor (SRF) of 'No Floor' refect Fitch's view that senior creditors cannot rely on receiving full extraordinary support from the sovereign in the event of the bank becoming non-viable. The EU's Bank Recovery and Resolution Directive provides a framework for resolving banks that is likely to require senior creditors participating in losses, if necessary, instead of or ahead of a bank receiving sovereign support.

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Realkredit's SR of '1' refects an extremely high probably that support would be provided by Danske, if required. In Fitch's view, Danske would have a high propensity to support Realkredit given the latter's role as the group's main domestic mortgage provider. Any required support would likely be manageable relative to Danske's ability to provide it.

SUBORDINATED DEBT AND OTHER HYBRID SECURITIES

Danske's Tier 2 debt is rated two notches below its VR to refect the above-average loss severity of this type of debt. Additional and legacy Tier 1 securities are rated four notches below Danske's VR to refect higher-than- average loss severity risk of these securities (two notches) as well as the high risk of non-performance (an additional two notches). Our assessment is based on the bank operating with a CET1 ratio comfortably above maximum distributable amount thresholds and our expectation that this will continue.

RATING SENSITIVITIES

DANSKE

IDRS, VR, NON-PREFERRED DEBT

Factors that could, individually or collectively, lead to positive rating action/upgrade:

An upgrade of Danske would require i) a completion of AML investigations and clarifcation of potential fnes; ii) an expected CET1 ratio of at least 15% net of AML settlements; iii) a sustainable reduction of impaired loans ratio below 2%; and iv) a successful implementation of the bank's transformation plan demonstrated by a durable recovery of the operating proft/RWAs ratio to at least 2.5%.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

The bank has sufcient rating headroom to withstand a downward revision of our assessment of asset quality and proftability by one notch that could be triggered by the severe delays to economic recovery expected by Fitch. A substantial and durable CET1 ratio erosion below 14% would lead to a downgrade, which could be driven by an AML fne considerably larger than the bank's current loss absorption capacity.

We could also revise the Outlook to Negative if we reassess that the bank's AML fne absorption capacity may be insufcient. This could be triggered if we expect Danske's CET1 ratio surplus over its requirement to shrink materially below 250bp.

PREFERRED DEBT, DCR AND DEPOSIT RATINGS

Danske's long-term senior preferred debt, DCR and long-term deposit ratings are sensitive to a change in the bank's Long-Term IDR. The ratings could be downgraded by one notch if the bufer of senior non-preferred and more junior debt falls below 10% of adjusted risk-weighted assets (excluding Realkredit) if the group includes senior preferred debt in its resolution bufer.

REALKREDIT

IDRS, VR

Factors that could, individually or collectively, lead to positive rating action/upgrade:

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Realkredit's IDR could be upgraded if Danske's IDRs are upgraded, assuming it retains its important role within the group. An upgrade of Realkredit's VR is unlikely in the near term given its monoline business model. In the longer term, an upgrade would be contingent on Realkredit's broadening its product ofering, providing it with signifcantly more diversifed revenue streams.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

We would downgrade Realkredit's ratings if we expect that it will not be able to maintain its CET1 ratio above 14% or restore it to that level within a short period of time. This could be due to signifcantly higher-than- expected loan impairment charges driven by a prolonged recession, high unemployment and material property price correction.

In addition, a downgrade of its parent's VR by more than one notch could lead to a downgrade of Realkredit's ratings, given the high correlation we believe exist between the two ratings.

An adverse change in investor sentiment that requires extraordinary support from the parent due to materially weakening Realkredit's ability to access competitively priced covered bond funding would be rating negative. An increased reliance on international debt investors who may prove less stable during fnancial stress would also put pressure on ratings.

SUPPORT RATING AND SUPPORT RATING FLOOR

An upgrade of Danske's SR or upward revision of the SRF would be contingent on a positive change in Denmark's propensity to support its banks. While not impossible, this is highly unlikely, in Fitch's view.

Realkredit's SR of '1' is sensitive to a change in Danske's propensity or ability to provide support.

SUBORDINATED DEBT AND OTHER HYBRID SECURITIES

As subordinated debt and other hybrid securities are notched down from Danske's VR, their respective ratings are primarily sensitive to a change in Danske's VR. They are also sensitive to Fitch changing its assessment of the probability of their non-performance risk relative to the risk captured in Danske's VR

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defned as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defned as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specifc best- and worst-case scenario credit ratings, visit https://www.ftchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

Public Ratings with Credit Linkage to other ratings

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