Credit Opinion: L-Bank

Transcription

1 Credit Opinion: L-Bank Global Credit Research - 07 Mar 2014 Karlsruhe, Germany Ratings Category Moody's Rating Outlook Stable Bank Deposits Aaa/P-1 Issuer Rating Aaa Senior Unsecured Aaa Subordinate MTN (P)Aaa Commercial Paper -Dom Curr Other Short Term -Dom Curr P-1 (P)P-1 Contacts Analyst Phone Andrea Wehmeier/Frankfurt am Main Michael Rohr/Frankfurt am Main Carola Schuler/Frankfurt am Main Johannes Binder/Frankfurt am Main Key Indicators L-Bank (Unconsolidated Financials)[1] [2]12-12 [2]12-11 [2]12-10 [2]12-09 [2]12-08 Avg. Total Assets (EUR million) Total Assets (USD million) 70, , , , , , , , , ,043.5 [3]3.5 [3]2.1 Tangible Common Equity (USD million) 3, , , , ,751.6 Tangible Common Equity (EUR million) 2, , , , ,979.5 [3]9.6 [3]8.2 Net Interest Margin (%) [4]0.6 PPI / Average RWA (%) Net Income / Average RWA (%) [5]1.4 [5]0.7 (Market Funds - Liquid Assets) / Total Assets (%) Core Deposits / Average Gross Loans (%) [4] [4] [5] [5]11.2 Tier 1 Ratio (%) Tangible Common Equity / RWA (%) Cost / Income Ratio (%) [4]34.9 Problem Loans / Gross Loans (%) [4]6.5 Problem Loans / (Equity + Loan Loss Reserves) (%) [4]50.0 Source: Moody's [1] All figures and ratios are adjusted using Moody's standard adjustments [2] Basel II; LOCAL GAAP [3] Compound Annual Growth Rate based on LOCAL GAAP reporting periods [4] LOCAL GAAP reporting periods have been used for average calculation [5] Basel II & LOCAL GAAP reporting periods have been used for average calculation Opinion

2 SUMMARY RATING RATIONALE We assign long-term ratings of Aaa/Prime-1 to L-Bank (Baden-Wuerttemberg's development bank). The ratings are based on the guarantee framework provided by the State of Baden-Wuerttemberg (Aaa, stable). The bank's liabilities are explicitly and unconditionally guaranteed by the state, L-Bank's ratings qualify for a "credit substitution approach" that is based on a full risk transfer to the guarantor. We recognize L-Bank's (1) important role as the region's public development bank; (2) stable, but modest core operating performance; and (3) an improving, but still substantial risk profile. These factors, however, are not material for L-Bank's Aaa/Prime-1 ratings. Rating Drivers - Ownership support via extensive guarantee framework - L-Bank's franchise is defined by its role as the State of Baden-Wuerttemberg's economic development bank - Asset quality is improving, though concentrations risks and euro area periphery exposure remain substantial - Shift in profit distribution enabled the bank to significantly improve its capitalisation - Favourable refinancing conditions bolster profitability - Liquidity risk is low given good market access and fall-back options Rating Outlook The outlook on L-Bank's Aaa rating is stable, reflecting the outlook on its owner, the State of Baden-Wuerttemberg. What Could Change the Rating - Up The Aaa/Prime-1 ratings are at their upper ceilings and therefore cannot be upgraded. What Could Change the Rating - Down Negative rating pressure could result (1) from a weakening in the credit profile of the guarantor, the State of Baden-Wuerttemberg; and (2) if the strong support mechanisms were weakened or disallowed which, in our view, is currently unlikely. DETAILED RATING CONSIDERATIONS OWNERSHIP SUPPORT VIA EXTENSIVE GUARANTEE FRAMEWORK L-Bank's Aaa/Prime-1 ratings are underpinned by the support mechanisms of its owner, the Federal State of Baden-Wuerttemberg and benefit from: 1) An explicit and unconditional guarantee for its liabilities from the State of Baden-Wuerttemberg, providing creditors with direct recourse to the obligor (the Federal State). 2) A strong public-sector support arrangement in the form of Anstaltslast (maintenance obligation) and Gewaehrtraegerhaftung (statutory guarantee) provided by the State of Baden-Wuerttemberg (the state) for the bank's obligations. The maintenance obligation or institutional liability (Anstaltslast) requires the bank's owner to ensure that the entity has sufficient funds to meet all of its obligations on a timely basis. The owner's statutory obligation (Gewaehrtraegerhaftung) means L-Bank benefits from the unconditional support of the Federal State for all its liabilities, once their claims cannot be satisfied fully out of the bank's assets. The explicit and unconditional guarantee, however, provides creditors with the direct recourse to the obligor allowing for timely payment of all obligations. Accordingly, L-Bank's liabilities are explicitly and unconditionally guaranteed by the State of Baden-Wuerttemberg. L-BANK'S FRANCHISE IS DEFINED BY ITS ROLE AS BADEN-WUERTTEMBERG'S ECONOMIC DEVELOPMENT BANK Similar to other development banks, we consider L-Bank's franchise value to be incomparable with those of

3 commercially oriented banks. L-Bank operates under a policy mandate as stipulated by the local law (L-Bank Act), primarily supporting the state in matters of regional economic development and social-housing projects. L-bank's statutes detail the scope of its business activity including the use of products to perform its role in development lending as well as its risk diversification and liquidity management activities. It holds a full banking license and is regulated by the German banking supervisory authorities (Bundesbank and BaFin). ASSET QUALITY IS IMPROVING; THOUGH CONCENTRATION RISKS AND EURO AREA PERIPHERY EXPOSURE REMAIN SUBSTANTIAL L-Bank's risk positioning reflects its defined role as a public-sector bank as prescribed in the L-Bank Act and statutes. Overall, it needs to manage highly concentrated exposure to the financial sector due to its investment and liquidity portfolio as well as its development lending book. However, we consider the dual recourse for its development loan portfolio to represent an important risk mitigant. Despite material recapitalisation measures for European banks, risks to their stability remain substantial as (1) the fundamental issues of sovereign debt remain substantially unresolved, and (2) recessions in several major European economies could adversely affect, and potential destabilise, banking systems in the affected countries. L-Bank's economic development and infrastructure lending are of low risk. Loans are either granted directly or as development loans through the banking sector (on-lending business), with the commercial banks assuming the credit risk of the ultimate borrower. This concept is a mitigant to L-Bank's credit risk and materially reduces economic capital requirements. However, in cases of bank failure, L-Bank would also benefit from its priority of claims over receivables from the ultimate borrowers, thereby providing another important layer of recourse to the bank. In 2012, total assets including off-balance-sheet guarantees and commitments increased further to EUR80 billion (2011: EUR78 billion), due to the EUR2 billion expansion of L-Bank's security portfolio and new commitments in development lending which added EUR1.5 billion to customer loans. Loan growth has recently decelerated, after a period of expansion that was, for example, driven by the EUR5.9 billion financing of the State of Baden- Wuerttemberg's purchase of EnBW Energie Baden-Wuerttemberg AG (EnBW, A3, negative) in While this financing is backed by a guarantee from its owner (the Federal State of Baden-Wuerttemberg), it still represents a significant concentration in the bank's loan portfolio, which is more difficult to handle for a board or management than concentrations with external parties, in our view. L-Bank's loan portfolio includes higher-risk legacy exposures, which are part of the housing development portfolio (Wohnbaufoerderung) in the German Free State of Saxony. We note that L-Bank has made significant progress in reducing the portfolio to EUR3 billion as of year-end 2012 (2008: EUR4.1 billion). Actual loan losses in relation to the total portfolio are currently manageable and, considering that the housing portfolio in the Free State of Saxony held by L-Bank now appears to be fairly seasoned, we do not expect any further substantial deterioration of credit quality in this area. In combination with existing satisfactory provisioning levels, these factors have helped to limit previous concerns regarding risks relating to the credit portfolio. Problem loans only account for 31% of equity and loan-loss reserves (35% in 2011). As such, we believe that the current level of provisioning effectively limits future unexpected losses. L-Bank manages an investment portfolio - comprising public-sector and corporate issuers - including CDS protection sold (EUR27 billion YE2012). Thereof, EUR9.5 billion consists of exposure to European issuers, of which EUR5.5 billion relates to financial institutions and EUR3.8 billion relates to the public sector. Of the total, EUR2.2 billion (83% of Tier 1 capital) is invested in euro area periphery countries (2011: EUR2.5 billion), which includes EUR781 million secured Pfandbriefe and covered bonds. L-Bank's credit default swap (CDS) portfolio (protection sold) was still at a significant EUR4.5 billion as of year-end This factor is partially mitigated by the decrease of negative market values to EUR93 million as of year-end 2012 from a negative EUR454 million as of year-end of 2011, primarily driven by spread tightening. Although we expect the exposure to gradually diminish, we continue to note risks associated with the extent of concentrations in the bank's sizeable investment and CDS portfolio, which render the bank vulnerable to adverse events in the context of the euro area debt crisis. As the bank reports under local GAAP accounting, we note the potential negative impact on profitability and capital in an adverse scenario. SHIFT IN PROFT DISTRIBUTION ENABLED THE BANK TO SIGNIFICANTLY IMPROVE ITS CAPITLISATION We consider that L-Bank's capitalisation improved substantially in 2012 and is now more solid in light of its business and financial risk profile. L-bank reported a Tier 1 ratio of 14.2% in 2012 (2011: 9.7%), based on retained earnings, representing a major shift in profit distribution. According to Moody's calculations, the bank's leverage

4 ratio was at 3.8%. L-Bank remains the only development bank amongst Moody's rated universe where profit distribution is not fixed (either legally or statutory) and the entity therefore remains dependent on the decisions of its owner, the State of Baden-Wuerttemberg. L-Bank applies the Standard Approach under Basel II and benefits from exemptions for risk-weights including the zero risk-weight for loans to the federal state including guaranteed loans, credit risks to German public-sector financial institutions; a reduced risk weight of 20% applies for pass-through loans to commercial banks. The bank's core capital, before the attribution of the annual profit, recorded a substantial increase to EUR2.6 billion in 2012 based on retained earnings, and includes EUR350 million reserves for general banking risks under section 340g of the German Commercial Code. L-Bank is listed among the banks deemed to be significant under the single supervision mechanism and as such subject to the ECB's comprehensive assessment that consists of a supervisory judgment on key risks, an asset quality review and a stress test; results of the assessment are to be published in October FAVOURABLE REFINANCING CONDITIONS BOLSTER PROFITABILITY As a public sector bank, L-Bank aims to achieve moderate profit levels to ensure the sustainability and continuation of the bank's development financing activities (rather than seeking to maximise profits). The bank's profitability will remain supported by, among other things, corporate tax exemptions. L-Bank's revenues are predominantly based on interest income, benefiting from its favourable access to capital markets and particularly the low borrowing costs in international capital markets including short-term funding given the backing by the State of Baden-Wuerttemberg in an environment driven by `safe haven' flows. During 2012, net interest income (NII) decreased to EUR296 million (2011 EUR324.4 million). This reduction includes the accounting effects attributable to the reporting of interest subsidies at net-present value. Adjusting the NII for this accounting effect (in total EUR140 million interest subsidies in 2012) would have resulted in an increase in NII to EUR438 million (2011: EUR420.8 million), reflecting continued favourable refinancing conditions. For 2012, L-Bank's local GAAP net income was EUR147 million (2011: EUR641 million), mainly attributable to the reversal of EUR353 million of loan loss reserves in 2011 to strengthen Tier 1 capital. Non-interest income decreased to EUR62 million (2011: EUR68 million) driven by slightly lower fee and commission income of EUR39 million (2011: EUR42.2 million), and other income of EUR17million. Given that the bank's economic development activities principally comprise low margin businesses, net interest margins are relatively low, providing only a limited cushion against adverse developments on the asset side, as outlined above. The profitability outlook for L-Bank largely relies on its access to capital markets and on funding costs, given that (1) the bank's funding structure is gradually being shortened; and (2) it is dependent on the perception of the credit quality of Germany and the German public sector, which is typical for public-policy banks. The adjusted cost-toincome ratio - at around 35% in recent years - compares well with that of other German development banks. LIQUIDITY RISK IS LOW GIVEN GOOD MARKET ACCESS AND FALL-BACK OPTIONS L-Bank is highly reliant on market funding and depends on regular market access not only for the new business it underwrites, but also for existing business. However, the group's high standing as a quasi-sub sovereign prime issuer has thus far ensured uninterrupted access to domestic and international capital markets at very attractive rates. We expect the favourable conditions to remain broadly unchanged and consider the risk of market access interruption to be sufficiently mitigated by (1) L-Bank's security portfolio; and (2) the bank's ability to access the ECB for repo transactions collateralized by its own (federal government guaranteed) bonds. L-bank's medium- and long-term capital market funding needs are typically in the range of EUR7-10 billion per year - out of its EUR30 billion debt issuance programme and benchmark bonds. We note that L-Bank's wholesale funding profile is gradually being shortened following the expansion of its commercial paper programme to EUR10 billion and its other money market operations. The consequent maturity mismatches over the short and medium term expose the bank to certain yield-curve risks, which could pressure profitability. In order to cover potential unforeseen liquidity shortfalls, L-Bank maintains a sizeable portfolio of ECB-eligible assets. Our credit assessment incorporates the risks represented by confidence-sensitive money market funding and the resulting funding imbalances. Due to the explicit and unconditional guarantee of the State of Baden-Wuerttemberg, L-bank's issued debt attracts a zero-risk weighting for capital adequacy requirements for investors.

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