JUNE 25, 2013 SUB-SOVEREIGN CREDIT ANALYSIS Kommunalbanken AS Oslo, Norway Table of Contents: SUMMARY RATING RATIONALE 1 International Peer Comparisons 1 RATING OUTLOOK 1 WHAT COULD CHANGE THE RATING DOWN 1 ISSUER OVERVIEW 2 KEY RATING FACTORS 2 Institutional Framework 2 Financial Performance 2 Capital Adequacy 3 Funding and Liquidity 4 Asset Quality 5 Risk Positioning 6 APPLICATION OF JOINT-DEFAULT ANALYSIS 6 RATING HISTORY 7 ANNUAL STATISTICS 8 MOODY S RELATED RESEARCH 12 Summary Rating Rationale The Aaa long-term and Prime-1 short-term ratings with stable outlook assigned to Kommunalbanken AS (KBN) are supported by its strong market share in lending to local governments in Norway. The ratings also reflect:» Classification as state instrumentality and 100% ownership by the government of Norway (Aaa, stable) reinforces its role as state mandated funding vehicle for Norwegian local governments;» Strong financial fundamentals and growth in its capital base, which has been instrumental in KBN becoming the sector s dominant lender;» Strong standing in funding markets and good liquidity position, however no possibility to repo its loan book with the central bank;» Prudent risk management including very limited appetite for currency and interest rate risks Analyst Contacts: LONDON +44.20.7772.5454 Roshana Arasaratnam +44.20.7772.5302 Vice President roshana.arasaratnam@moodys.com David Rubinoff +44.20.7772.1398 Managing Director - Sub Sovereigns david.rubinoff@moodys.com MADRID +34.91.768.8200 Sebastien Hay +34.91.768.8222 Vice President - Senior Credit Officer sebastien.hay@moodys.com This Credit Analysis provides an in-depth discussion of credit rating(s) for Kommunalbanken AS and should be read in conjunction with Moody s most recent Credit Opinion and rating information available on Moody's website. International Peer Comparisons KBN s is rated in line with other Nordic specialised lenders. KBN is 100% owned by the Kingdom of Norway, unlike its Nordic peers which are owned mainly by the local government sector. KBN s lending carry a 20% risk weighting, unlike Nordic peers whose lending is zero risk weighted. KBN cannot repo its loan book with its central bank, unlike some specialised lender peers. Rating Outlook The outlook on KBN s ratings is stable. What Could Change the Rating Down Downward pressure on the rating may be triggered by a change in the central government s ownership of KBN. The rating could also come under pressure if KBN s mandate to fund the Norwegian local government sector was diminished. A downgrade in the sovereign rating could also prompt a negative rating action on KBN.
Issuer Overview KBN was established in 1999 through an Act of Parliament, 1 as a continuation of Norges Kommunalbank, which had been set up in 1926. KBN is not a profit maximising entity. Like its predecessor, KBN is mandated to lend solely to local governments, inter-local governmental entities or entities guaranteed by local or central governments. KBN is supervised by the Norwegian FSA ( Finanstilsynet ). Key Rating Factors Institutional Framework The government-related footprint on KBN is strong, reflecting its establishment via legislation, its full ownership by the central government and the strict oversight by the Ministry of Local Government and Regional Development and supervision by the Norwegian FSA ( Finanstilsynet ).» Norwegian Government regards KBN as fulfilling a public-policy function by providing low-cost funding to domestic local governments.» The central government provides a maintenance obligation to KBN stating that government considers it to be its duty to ensure that KBN is always in a position to meet its financial obligations.» Whilst KBN operates under the supervision of the Norwegian Financial Supervisory Authority (Finanstilsynet), it also maintains close relations with the Ministry of Finance and the Ministry of Local Government, with which it consults on its financial plans, rates of return, target market shares and sufficiency of capital levels to maintain its public mission. KBN is the market leader for local government lending KBN holds a market share of around 50% of all local government financing in Norway, including municipal companies, up from 36%% at year-end 2006. Effectively all municipalities and counties in Norway borrow from KBN, including the City of Oslo (Aaa, stable). Its main historical competitor has historically been KLP Kommunekreditt Norge AS (recently sold to Kommunal Landspensjonkasse (KLP, A2, negative)). KLP is a mutual pension and life insurance company for Norwegian local governments. KLP s market share of municipal lending has dropped from more than 20% in 2007 to less than 10% in 2012. In recent years municipalities have increasingly accessed the capital markets using their own funding programs. In 2012 this type of funding provided for approximately 30% of all local government lending in Norway. Financial Performance Net interest margins are high compared to peers Like other specialised lenders, KBN's profitability depends on the spread between its lending rates and funding costs. Moody s expects net interest margin to remain at a historical high level as KBN prepares for implementation of new regulation, which might require it to hold more capital. 1 Act no.68 of 1999 2 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
KBN recorded sound financial results in 2012, driven partially by a higher net interest margin (NIM), as shown in Exhibit 1. KBN s NIM is at the higher end compared to peers. Unrealised gains were however the most significant contributor to higher net income. Moody s expects unrealised gains to remain volatile in line with financial markets. Profit for 2012 was NOK 1876 million, up from NOK 724 million the previous year. Aside from the above factors, Moody s expects net income to remain stable, given KBN s unchanged mandate. EXHIBIT 1 Development in net interest margin (percentage): 2002-2012 0.70 0.65 0.60 0.55 0.50 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00 0.32 0.30 0.26 0.20 0.20 0.21 0.31 0.50 0.47 0.51 0.62 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: KBN Operating expenses remain low KBN has a low ratio of cost-to-total-assets at 4bps in 2012, up from 3bps in 2011. This ratio is low compared to peers and indicates that KBN is an efficient organisation. The total number of employees has risen to 54 from 42 in 2008, indicating that only modest staff increases have been necessary to meet the requirements of a more volatile post-lehman environment. Capital Adequacy Capital position is consistent with Nordic peers KBN s capital position is good considering its low risk assets. KBN has never recorded a loan loss during 86 years of operation. Its lending nevertheless carry a 20% risk weight, as instructed by the Norwegian FSA. In comparison, Nordic peers report a zero risk weight on their lending. KBN s risk weighted capital ratios are consequently lower compared to peers. In our view, the creditworthiness of the Norwegian local government sector is comparable with Nordic peers. Capital is low in relation to total assets, as is the case for peers. In December 2012, equity made up 2.1% of total assets. Under Basel 3 rules, a 3% leverage ratio requirement could come into force. We understand that KBN intends to comply with this ratio if it becomes a requirement. To comply with the ratio KBN can refrain from paying dividends and slow down lending growth, as it did in 2012. We also see further capital injections from the owner as a possibility. 3 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
EXHIBIT 2 Loan development (NOK million): 2002-2012 Gross loans Equity Loans 240,000 220,000 200,000 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 Source: KBN 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Equity Funding and Liquidity Funding position is consistently strong KBN employs a diversified funding strategy. It issues debt in several currencies, in several geographies using different funding instruments, to different institutional investors. We view this strategy as prudent because alleviates KBN from being reliant on a single source of funding. In recent years financial markets have exhibited severe volatility, with some financial institutions finding it difficult to access funding markets. During these times KBN has funded itself at very low cost, resulting in our view that KBN is viewed as a safe haven. Alike its peers, KBN issues debt with option-like features. Such structured funding could suddenly shorten KBN s liability profile. KBN however assumes that these structures are called immediately when possible. Refinancing risk is also mitigated by KBN s strong standing in funding markets and its liquidity portfolio which forms approximately 50% of its lending book. EXHIBIT 3 Currency Split of KBN Debt Issuance, 2012 EXHIBIT 4 Investors Per Geography, 2013 GBP 5% AUD 6% NOK 3% Others 6% USD 45% Middle East 9% Non-Japan Asia 9% Americas 9% United States 26% JPY 35% Europe 23% Japan 24% Source: KBN Source: KBN 4 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
Liquidity position underpinned by large liquidity reserve The liquidity portfolio consists of highly rated investments, diversified across several countries, with a short maturity. 27% of investments are Aaa rated and 19% of investments fall into the Aa rating range. An additional 52% of investments carry the highest possible P-1 short-term rating. A small proportion of investments have no rating however this is risk towards Nordic municipalities which we view as creditworthy. KBN aims to maintain liquid means to sustain operations for 12 months if funding markets become unavailable. KBN also has access to a committed NOK700 million liquidity line with a large Norwegian financial institution. KBN however cannot repo its loan book with its central bank, unlike some peers. KBN is compliant with the liquidity coverage ratio (LCR) as of June 2012. KBN s LCR ratio stood at 165% compared to a minimum requirement of 100%. The ratio compares the available high quality liquid assets with net cash outflows during the next 30 days. We expect KBN to remain compliant with the ratio due to its large liquidity portfolio. Asset Quality Sound credit risk supported by well-diversified asset quality KBN s stand-alone credit strength rests on the high quality of the local government sector that it serves. We view the Norwegian local government sector as stable, tightly managed and appropriately funded. During 86 years of operation KBN has never suffered a loss on its loan portfolio.» Large share of governmental services. Norwegian local governments are among the most regulated and supervised in Europe. Local authorities are responsible for approximately two-thirds of total public spending. We anticipate that this high level of integration into the social fabric of the country, combined with effective controls by the central government to ensure prudence and to balance funding where necessary would result in support from the sovereign to individual local governments in highly infrequent cases of financial distress.» Lack of revenue flexibility, although manoeuvrability at the national level mitigates risk. Combining centrally directed tax rates and detailed equalisation formulas, local government funding is highly stable and closely tied to the costs of local-service provision. Large-scale reforms, such as shifting services between the national government, counties and municipalities, occur over an extensive period of consultation and financial planning, which adds to predictability.» Local governments tightly monitored; interventions in advance of imminent crises. Accounting standards are good and government oversight is comprehensive. Local governments may not budget for an operating deficit and must cover any resulting deficit in their budgets for the next three years. Under the Local Government Act, local governments may not file for bankruptcy and must follow legally specified procedures for workouts. Local governments may be placed under review for closer monitoring, although cases of direct intervention by the national government are rare. KBN s loan exposures are well managed.» KBN is not obliged to approve all loan requests, and has full control of its portfolio. It also operates an internal rating model where budgets and debt levels of municipalities are closely monitored. If a municipality wishes to increase its loans and operates with per capita debt levels exceeding NOK100,000, the loan request is referred to the board. Moody's feels that this added risk control is credit positive. 5 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
» KBN s loan portfolio is concentrated to Norway yet diversified across a large number of borrowers. At year-end 2012, the ten largest credits accounted for approximately 23% of loans and the largest individual borrower (Kristiansand Kommune) for 3.3%.» The balance of lending by client type has remained stable, with the loan booking shifting from municipal lending towards companies owned by municipalities. In 2012 municipalities received about 64% of loans, counties 17% and municipal enterprises, companies and other 19% of loans. Risk Positioning Governance structure emphasises local governmental footprint The governance structure of KBN, through its supervisory board and board of directors, emphasises the important role that it plays within the broader sphere of government financing. The supervisory board is appointed by the Ministry of Local Government and Regional Development. Current 11 members represent the local government sector. The board of directors represent a wide array of backgrounds and they number nine in total. They are elected at the annual general meeting except from two members who are elected by the company employees. Very low appetite for currency and interest rate risks KBN has almost no currency exposure. An absolute 10 percentage point shift in foreign currencies, relative to NOK, would translate into a NOK1 million loss. Effectively no appetite for currency risks is consistent with KBN s mandate and its peers. KBN s appetite for interest rate risks is also very limited. A 100 bps shift in interest rates would translate into a NOK 13 million loss, which is a tiny amount compared to total equity (NOK 7.4 billion) or assets (NOK 349 billion). Counterparties to hedging agreements are mainly internationally well know financial institutions with a minimum A2 rating. KBN requires its counterparties to sign credit support annexes (CSA) and as collateral it accepts USD and EUR cash, only. Adequate operational risk systems To maintain its efficiency and minimise risks, KBN has standardised most procedures and loan agreements. Staff is trained to take over other tasks should the need arise. It shares an IT system with Sweden s Kommuninvest (Aaa, stable), and has agreements in place to use platforms at the Ministry of Local Government and Regional Development as a backup in case of system failure. Application of Joint-Default Analysis As a reflection of the application of Moody s Joint Default Analysis Methodology for Government- Related Issuers, KBN s rating is composed of three principal inputs:» A baseline credit assessment (BCA) of Aa2;» A very high likelihood of extraordinary support from the government of Norway (Aaa, stable), reflecting the central government s 100% equity position in KBN, high interconnectedness between municipalities and the central government, and the maintenance obligation of the central government to both KBN and individual municipalities in case they experience a financial difficulty. 6 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
» A high default dependence between KBN and the government of Norway, reflecting their relation to the local government sector and KBN s public policy mandate. Rating History Kommunalbanken AS Date Rating Action 16 December 1999 Aaa Rating Assigned 7 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
Annual Statistics Kommunalbanken AS 12/31/08 12/31/09 12/31/10 12/31/11 12/31/12 Summary Balance Sheet (NOK million) Cash & central bank 0 0 1,251 801 4,910 Due from banks 3,900 988 6,779 2,350 1,030 Securities 73,018 69,649 95,610 116,657 102,223 Gross loans 120,935 153,040 185,679 210,189 221,996 Loan loss reserves (LLR) - - - - - Insurance assets - - - - - Fixed assets 8 12 14 11 11 Other assets 18,373 8,243 26,159 36,893 18,784 Total assets 216,236 231,932 315,492 366,901 348,954 Total assets (USD million) [1] 30,896 40,150 53,871 62,650 62,777 Demand deposits - - - - - Savings deposits - - - - - Due to banks 1,922 1,051 8,814 11,915 6,041 Market Funds 200,087 223,566 288,093 336,942 317,471 Insurance liabilities - - - - - Other liabilities 10,438 2,802 13,572 10,707 16,379 Total liabilities 212,448 227,419 310,479 359,564 339,891 Subordinated debt 1,583 952 978 2,743 1,670 Shareholders' equity 2,205 3,560 4,035 4,594 7,394 Total capital funds 3,788 4,512 5,013 7,337 9,064 Total liabilities & capital funds 216,236 231,931 315,492 366,901 348,955 Derivatives - notional amount 414,581 462,299 541,971 601,050 553,498 Derivatives - replacement value -- -- -- -- -- Contigent liabilities -- -- -- -- -- Risk weighted assets (RWA) 30,202 35,970 46,934 54,097 57,499 Assets under management (NOK million) -- -- -- -- -- Number of employees 42 43 48 48 54 8 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
Kommunalbanken AS 12/31/08 12/31/09 12/31/10 12/31/11 12/31/12 Summary Income Statement +Interest income 8,998 4,846 5,034 6,730 6,872 -Interest expense 8,473 3,794 3,837 5,148 4,839 =Net interest income 525 1,052 1,197 1,582 2,033 +Trading income - - - - - +Fees & commissions - - - - - +Insurance income (net) - - - - - +Other operating income 1 1 - - - =Operating income 526 1,053 1,197 1,582 2,033 -Personnel expenses 46 53 60 58 65 -Other operating expenses 45 53 50 53 59 = Operating funds flow 435 947 1,087 1,471 1,909 -Amortisation/depreciation 5 5 5 4 4 (Total operating expenses) 96 111 115 115 128 =Preprovision income (PPI) 430 942 1,082 1,467 1,905 -Loan loss provisions (LLP) (2) - - - - +Other non operating adjustments (2) 222 (89) (575) 671 +Extraordinary profit / loss 115 781 41 109 29 =Pretax income 545 1,945 1,034 1,001 2,605 -Taxes 153 547 293 276 728 =Net income 392 1,398 741 725 1,877 -Minority interests - - - - - =Net income (group share) 392 1,398 741 725 1,877 Growth Rates (%) Gross loans 15.5 26.5 21.3 13.2 5.6 Total assets 50.5 7.3 36.0 16.3 (4.9) Customer deposits (demand and savings) -- -- -- -- -- Net interest income 85.9 100.4 13.7 32.2 28.5 Fee and commission income -- -- -- -- -- Operating expenses 14.6 15.8 3.6-11.3 Preprovision income 115.4 119.1 14.8 35.6 29.9 Net Income 156.0 256.5 (47.0) (2.2) 158.9 9 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
Kommunalbanken AS 12/31/08 12/31/09 12/31/10 12/31/11 12/31/12 Income Statement in % Average Risk Weighted Assets Net interest income 1.93 3.18 2.89 3.13 3.64 Trading income - - - - - Fee and commission income - - - - - Insurance income - - - - - Operating income 1.93 3.18 2.89 3.13 3.64 Operating expenses 0.35 0.34 0.28 0.23 0.23 Preprovision income 1.58 2.85 2.61 2.90 3.41 Loan loss provisions (0.01) - - - - Extraordinary profit 0.42 2.36 0.10 0.22 0.05 Net income 1.44 4.23 1.79 1.44 3.36 Liquidity, Funding & Balance Sheet Composition Avg. liquid assets % avg. total assets 31.79 32.92 31.84 32.74 31.85 Avg. gross loans % avg. total assets 62.68 61.13 61.88 58.01 60.37 Avg. customer deposits % avg. total funding - - - - - Avg. interbank funds % avg. total funding 1.16 0.69 1.88 3.19 2.65 Avg. market funds (excl. interbank) % avg. total funding 98.00 98.72 97.75 96.24 96.69 Avg. sub debt % total funding 0.84 0.59 0.37 0.57 0.65 Avg. liquid assets % avg. customer deposits -- -- -- -- -- Avg. gross loans % avg. customer deposits -- -- -- -- -- Avg. market funds reliance 96.92 100.89 99.97 101.86 100.06 Avg. RWA % avg. total assets 15.13 14.76 15.14 14.81 15.59 Breakdown of Operating Income in % Net interest income % operating income 99.85 99.91 100.00 100.00 100.00 Trading income % operating income - - - - - Fees & commissions % operating income - - - - - Insurance income % operating income - - - - - Other operating income % operating income 0.15 0.09 - - - 10 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
Kommunalbanken AS 12/31/08 12/31/09 12/31/10 12/31/11 12/31/12 Profitability Annualised Yield on avg. earning assets (%) 5.29 2.30 1.97 2.18 2.10 Cost of interest bearing liabilities (%) 4.97 1.77 1.47 1.59 1.43 Net interest margin (%) 0.31 0.50 0.47 0.51 0.62 Recurring earning power (PPI % avg. assets) 0.24 0.42 0.40 0.43 0.53 Risk-weighted recurring earning power (PPI % avg. RWA) 1.58 2.85 2.61 2.90 3.41 Return on average assets (%) 0.22 0.62 0.27 0.21 0.52 Return on avg. RWA (%) 1.44 4.23 1.79 1.44 3.36 Return on equity (%) 17.79 39.28 18.36 15.78 25.39 Net interest income coverage of loan loss provisions (227.94) -- -- -- -- Loan loss provisions % preprovision income (0.54) - - - - Internal capital growth (%) 27.21 62.35 20.15 17.41 40.39 Dividend payout ratio (%) 6.25 1.68 3.17 3.10 1.15 Efficiency Cost/total assets 0.04 0.05 0.04 0.03 0.04 Cost/income ratio (operating expenses % operating income) 18.22 10.54 9.61 7.27 6.30 Operating expenses % average assets 0.05 0.05 0.04 0.03 0.04 Operating income / employee (NOK thousand) 12,553.20 24,497.67 24,937.50 32,958.33 37,648.15 Operating expenses / employee (NOK thousand) 2,287.59 2,581.40 2,395.83 2,395.83 2,370.37 PPI / employee (NOK thousand) 10,265.61 21,916.28 22,541.67 30,562.50 35,277.78 Total assets / employee (NOK million) 5,160.76 5,393.76 6,572.75 7,643.77 6,462.11 Capital Adequacy (Period End) Tier 1 ratio (%) 7.45 9.25 9.15 9.79 12.27 Total capital BIS ratio (%) 11.60 11.05 9.86 13.22 14.97 Shareholders' equity total assets (%) 1.02 1.54 1.28 1.25 2.12 Total capital ratio (%) 1.75 1.95 1.59 2.00 2.60 [1] USD figure uses historical exchange rate against the NOK. 11 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
Moody s Related Research Banking System Outlook:» Norway, February 2013 (148693) Special Comment:» Rating Impact of GRI Methodology for Non Depository Financial Institutions in the EMEA Region, June 2005 (93349) Analysis:» Norway, March 2013 (151455) To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. 12 JUNE 25, 2013 CREDIT ANALYSIS: KOMMUNALBANKEN AS
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