July 23, 2009 Luzerner Kantonalbank Primary Credit Analyst: Volker von Kruechten, Frankfurt (49) 69-33-999-164; volker_vonkruechten@standardandpoors.com Secondary Credit Analyst: Markus Schmaus, Frankfurt (49) 69-33-999-155; markus_schmaus@standardandpoors.com Table Of Contents Major Rating Factors Rationale Outlook www.standardandpoors.com/ratingsdirect 1 Standard & Poor's. All rights reserved. No reprint or dissemination without S&P's permission. See Terms of Use/Disclaimer on the last page. 735536 300025082
Major Rating Factors Strengths: Statutory guarantee provided by the Canton of Lucerne Very strong capitalization and funding position Strong and resilient asset quality The canton's outstanding, albeit declining, budgetary performance The canton's moderate debt burden and low net financial liabilities The canton's above-international-average wealth levels, low unemployment rate, and slight population growth Counterparty Credit Rating Weaknesses: Statutory guarantee does not address timeliness Limited regional and business diversification Pressure on tax rates, due to competition from neighboring cantons Some of the canton's contingent liabilities Rationale The ratings on Switzerland-based Luzerner Kantonalbank (LUKB) are equalized with those on the Swiss Canton of Lucerne () on the basis of a statutory guarantee, the canton's 63% ownership of the bank, and LUKB's importance for the local economy. The statutory guarantee legally obliges the canton to guarantee all of LUKB's liabilities, but does not address timely repayment of the bank's obligations. Standard & Poor's Ratings Services has equalized the ratings because--based on precedent--it believes that it is in the canton's interest to maintain LUKB as a going concern and to help it meet its obligations promptly. The statutory guarantee does not cover the bank's subsidiaries, such as private bank Adler & Co. The ratings on Lucerne are supported by its outstanding budgetary performance and management's commitment to maintaining a sound budgetary performance. In 2006-2008, the canton's operating surpluses reached an outstanding average of 13.9% of operating revenues, and surpluses after capital expenditures averaged 6.9% of total revenues. We expect Lucerne's debt to have reached a moderate 46% of operating revenues at year-end 2008, which is lower than the 58.2% median for the 'AA' category. Net financial liabilities are very low in an international context and were at 58.5% of total revenues in 2008. We believe the canton will post a significantly weaker, but still strong, budgetary performance between 2009 and 2012 because of the global and Swiss economic decline and fiscal challenges such as the effect of health care reform in Switzerland planned for 2012. We expect Lucerne's relative debt to increase slightly in the coming years and to stabilize at 50%-60% of total revenues, which is commensurate with the median value of the 'AA' rating category. In our opinion, the canton will be able to manage the effects of economic decline and remain committed to sound fiscal policies in the medium term. The ratings on the canton are also supported by its increasing population; high living standards; low unemployment rates, at 2.7% in May 2009 against the Swiss average of 3.5%; and high wealth of about 120% of the EU-27 GDP per capita. Standard & Poor s RatingsDirect July 23, 2009 2
Despite its legal form as a public-law joint-stock company--only one other cantonal bank has this status--lukb has most of the characteristics of its cantonal bank peers, such as a regional focus, prevalence of mortgage lending, lending to local small and midsize enterprises, and mass-affluent banking. Although Lucerne aims to gradually reduce its stake in LUKB to 61% from the current 62.6% by 2012, we understand it will remain the bank's majority shareholder in compliance with cantonal law, which stipulates a minimum stake of 51%. A full privatization of the bank is currently not envisaged. With total consolidated assets of Swiss franc (CHF) 22.7 billion on Dec. 31, 2008, LUKB enjoys high market shares of about one-third in loans and deposits in the canton. LUKB's regional concentration on the canton and its focus on secured residential real estate lending expose it to swings in the local economy and price fluctuations in property markets. Nevertheless, we expect LUKB's profitability to prove resilient during a potentially prolonged period of weak economic and capital market conditions because of what we regard as prudent enterprise risk management and a high proportion of stable revenues. Although risk costs will likely rise substantially from recent extremely low levels, we expect LUKB's provisioning needs to increase only gradually. This is because of the bank's strong underwriting standards, in our view, the dominance of granular and generally highly collateralized residential mortgage loans, and sound reserve coverage for the still very low level of problem loans. Increasing participations in syndicated lending with larger Swiss companies outside the core region have raised single-name concentration risk somewhat because these loans are mainly unsecured, but we believe these exposures are still in line with LUKB's generally limited risk appetite. LUKB continues to benefit from investors' flight to quality as substantial deposit inflows to state-guaranteed institutions continue. This further strengthens LUKB's already comfortable funding position and offers additional revenue opportunities to increasingly transfer business to LUKB. However, sizable inflows could make it increasingly difficult for LUKB to find investments with attractive risk-reward profiles that are in line with its strict guidelines. Although we expect commission income to suffer from customers' risk-averse behavior; reduced transaction volumes; and lower assets under management at LUKB's subsidiary Adler & Co., a small private-banking boutique; interest income should remain basically stable. In the short term, we expect this source of revenues to even increase, owing to a higher asset base and favorable interest rate environment with a steep yield curve, which increases additional contributions from asset-liability management. Another temporary factor is that margins from cheap customer funding are still attractive, but reduced rates on lending products, such as variable mortgages, could increasingly weigh on interest income over time. Competition in the saturated home market remains fierce, which means that slightly improving new business margins might not be sustainable. In our view, LUKB prudently controls market risk from asset-liability mismatches, which are relatively low. Liquidity remains very strong, with a significantly increased share of high-quality highly liquid securities and a sizable amount of cash. In our base case, we assume that LUKB's operating performance will comfortably buffer the expected increase in risk costs in the coming years. Consequently, we believe that capitalization will improve further, placing LUKB among the best-capitalized institutions in the world. LUKB's regulatory capital ratio was very strong at 13.3% at year-end 2008 or about 7% of total assets. Due to the lack of Pillar 3 data under Basel II, we have not yet calculated a risk-adjusted capital ratio. The ratings are constrained by Lucerne's relatively low tax-raising flexibility and some contingent liabilities. Legally, the canton has the right to set its own tax rates, but high tax competition with neighboring cantons considerably limits the potential for further tax increases in Lucerne. This is because cantons with very low tax rates like Schwyz (), Zug (not rated), and Obwalden (not rated) are only a few kilometers away. Lucerne adjusted its www.standardandpoors.com/ratingsdirect 3
tax code for 2008 to address residents' relatively high tax burden, effectively lowering its tax revenues. Lucerne's largest contingent liability is LUKB and Lucerne is LUKB's only guarantor. Lucerne divested parts of its shareholding in LUKB to repay a convertible bond in 2008, but we understand it plans to retain a stake of 61% over the medium term. A problem at LUKB could burden the canton's creditworthiness, which we currently view as unlikely, however. Unlike most Swiss cantons, Lucerne does not provide a formal guarantee for its pension fund. However, we are convinced that the canton will remain committed to this fund, which in 2008 had a coverage ratio of 91.9%, compared with 105.5% in 2007. Outlook The stable outlook on LUKB reflects that on Lucerne because the ratings and outlook on the guarantor have a direct impact on the ratings and outlook on LUKB. We understand that the cantonal guarantee will remain in force in the foreseeable future and that neither the guarantee mechanism nor the bank's ownership or legal structure will be materially altered in the short to medium term. Moreover, should any significant changes in LUKB's ownership or a withdrawal of the cantonal guarantee occur, we believe that any existing obligations will be grandfathered until maturity. The stable outlook on the canton reflects Standard & Poor's expectation that Lucerne will be able to weather the fiscal effects of the economic downturn and keep its budget deficits under control in the medium term. If the canton manages to close the economic gap to the Swiss average and achieves an excellent budgetary performance similar to that of recent years, there would be upward potential for the rating in the medium term. However, substantial tax losses or an unexpected increase in debt could put downward pressure on the ratings. Luzerner Kantonalbank--Financial Statistics --Year ended Dec. 31-- (Mil. CHF) As of March 31, 2009 2008 2007 2006 2005 2004 KEY DATA Adjusted assets 24,256 22,686 19,592 18,883 18,869 18,403 Risk adjusted assets (regulatory definition) N.A. N.A. 11,954 11,447 10,952 10,330 Customer loans (net) 18,110 17,751 16,785 16,278 15,732 14,984 Core/customer deposits 15,261 13,885 10,945 10,542 10,812 10,279 Adjusted common equity 1,649 1,538 1,499 1,474 1,408 1,323 Operating revenues 117 471 463 438 434 400 Noninterest expenses 62 282 225 213 222 222 Net income after extraordinaries 35 143 150 141 120 106 BALANCE SHEET COMPOSITION (% of Adj. Assets) Cash and money market instruments/assets(adj.) 13.00 10.73 6.31 6.19 8.84 10.63 Securities/assets(adj.) 6.52 4.98 3.72 3.69 3.51 3.51 Loans (net)/assets(adj.) 74.66 78.25 85.67 86.21 83.37 81.42 P&L COMPOSITION (% of revenues) Net interest income/revenues 69.94 66.13 60.58 63.33 64.24 66.08 Fee income/revenues 21.22 24.38 27.79 27.84 26.20 25.74 Standard & Poor s RatingsDirect July 23, 2009 4
Luzerner Kantonalbank--Financial Statistics (cont.) Market-sensitive income/revenues 7.58 8.26 10.61 6.92 7.35 5.56 Noninterest expense/revenues 53.26 59.82 48.54 48.66 51.21 55.55 New loan loss provisions/revenues 1.58 1.15 0.33 0.00 0.27 2.37 Net income/revenues 30.07 30.39 32.24 32.14 27.68 26.60 PROFITABILITY (%) Net interest income (taxable equiv.)/avg. earning assets 1.49 1.55 1.51 1.52 1.55 1.52 Noninterest expenses /assets(avg. adj.) 1.06 1.33 1.17 1.13 1.19 1.23 Net operating income before loss provisions/avg. risk assets (%) N.A. N.A. 2.04 2.01 1.99 1.74 Net operating income after loss provisions/avg. risk assets (%) N.A. N.A. 2.02 2.01 1.98 1.65 Net income/avg. risk assets (%) N.A. N.A. 1.28 1.26 1.13 1.04 Core earnings/avg. tang. common equity (ROE) (%) 10.73 9.57 12.39 12.21 11.82 10.05 Funding and Liquidity Customer deposits/funding base 72.06 70.89 64.32 64.01 65.85 64.41 Total loans/customer deposits 120.52 129.70 155.95 157.29 148.58 149.26 Customer loans (net)/assets (adj.) 74.66 78.25 85.67 86.21 83.37 81.42 CAPITALIZATION (%) Adjusted common equity/adjusted assets 6.80 6.78 7.65 7.81 7.46 7.19 Adjusted common equity/customer loans (net) 9.10 8.67 8.93 9.06 8.95 8.83 Adjusted common equity/risk assets N.A. N.A. 12.54 12.88 12.86 12.81 Adjusted total equity/risk assets N.A. N.A. 12.54 12.88 12.86 12.81 ASSET QUALITY (%) New loan loss provisions/avg. customer loans (net) 0.04 0.03 0.01 0.00 0.01 0.06 Net charge-offs/avg. customer loans (net) N.A. 0.17 0.14 0.19 0.21 0.27 Loan loss reserves/customer loans (gross) 1.53 1.43 1.66 1.83 2.07 2.33 NPA (excl. delinquencies)/customer loans + ORE 0.00 0.76 0.66 0.71 0.94 1.28 Net NPA/customer loans (net) + ORE (1.56) (0.68) (1.02) (1.14) (1.15) (1.08) Loan loss reserves/npa (gross) N.A. 188.51 252.34 256.60 219.50 182.26 CHF--Swiss franc. N.A.--Not available. Ratings Detail (As Of July 23, 2009)* Luzerner Kantonalbank Counterparty Credit Rating Certificate Of Deposit Senior Unsecured (5 Issues) Counterparty Credit Ratings History 12-Sep-2008 13-Aug-2007 29-Aug-2002 Sovereign Rating Swiss Confederation AA+/A-1+ AA+ AA/Positive/A-1+ AA/Stable/A-1+ AAA/Stable/A-1+ www.standardandpoors.com/ratingsdirect 5
Ratings Detail (As Of July 23, 2009)*(cont.) Related Entities Lucerne (Canton of) Issuer Credit Rating Senior Unsecured (1 Issue) *Unless otherwise noted, all ratings in this report are global scale ratings. Standard & Poor's credit ratings on the global scale are comparable across countries. Standard & Poor's credit ratings on a national scale are relative to obligors or obligations within that specific country. AA+ Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com Standard & Poor s RatingsDirect July 23, 2009 6
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