Strategic cooperation with Raiffeisenlandesbank Oberösterreich
Predominantly highly collateralized and granular loan portfolio
Product expertise in the state's residential real-estate promotion activities
Implicit support from State of Upper Austria (Land Oberoesterreich) as the majority shareholder
Weaknesses:
Low operating profitability and earnings quality compared with both national and international players
Reliance of business activity in low-margin public sector and mortgage lending
High proportion of income from equity holdings in relation to operating revenues
Improving, but still unsatisfactory, capitalization with adjusted total equity-to-risk assets of 5.6%
Rationale
The ratings on Oberösterreichische Landesbank AG's (Hypo OÖ) senior unsecured unguaranteed obligations benefit from three notches of implicit ownership support from the State of Upper Austria (AAA/Stable/A-1+) due to the latter's 51% ownership. Hypo OÖ is a "government-related entity" (GRE), qualifying for the category of commercial institutions. The ratings on Hypo OÖ also reflect the cooperation on selected areas with its strategic partner, Raiffeisenlandesbank Oberösterreich (RLB OÖ; not rated), its sound stand-alone risk profile, and its sound market share in state-related banking services.
Primary factors constraining the ratings are low profitability and earnings diversification, due to the bank's profile as a small regional bank as well as its narrow business focus. Hypo OÖ's market position outside its state-housing promotion business is still low because of the highly competitive market environment in Austria. An environment of low or even inverse interest rates in 2007 exposed Hypo OÖ to more volatile treasury income.
The vast majority of Hypo OÖ's lending activities consists of highly secured, small-ticket homeowner loans, mortgage loans to public-benefit housing associations with historically very low default risk, and low-risk public sector loans. As a result, Standard & Poor's Ratings Services expects loan loss provisions to remain at comparably low and stable levels. Although unsecured or commercial loans are gradually increasing, we expect Hypo OÖ to continue to focus on its core competencies and customer groups, based on its intimate knowledge of the local market.
Standard & Poor's considers that Hypo OÖ's interest margin will continue to be hindered by the historically low spread between lending and funding rates, combined with an already extremely low-margin environment in Austria. This will demand more efforts to increase the cooperation with RLB OÖ to partially offset the pressure on earnings through cost reductions. Profitability is only expected to be affected by higher (unsecured) funding costs after the loss of its guarantees on April 2, 2007, with a time lag due to increased prefunding activity in early 2007 and a high share of public sector and real-estate loans, which are eligible as collateral for covered bond issuance. The latter are less sensitive to the unsecured counterparty credit ratings.
Hypo OÖ's low capitalization in terms of adjusted total equity (ATE) reflects its investment in Salzburger Landeshypothekenbank AG (SLHYP; not rated). We expect capitalization to increase only slowly, given the low level of profitability, partially mitigated by the moderate dividend pay out of about 12%.
Outlook
Although Standard & Poor's considers that Hypo OÖ has made progress in the past to slightly adapt its business model to the loss of state guarantees within the limitations of a small regional bank, we expect that the majority of business will be state related for the time being. We do not expect major strategic adjustments in the near future. Compared with other European regional banks, we expect that Hypo OÖ will continue to lag behind in terms of profitability and earnings diversification. Although the bank's business performance remains unsatisfactory compared with other European regional banks, its close relationship to the state will allow a stable inflow of low-risk (but also low-margin) business.
The ratings might be lowered if the state reduces its commitment to Hypo OÖ or if the importance of Hypo OÖ for the state--predominantly reflected in providing services related to the state's housing promotion activities—were to mitigate. (For more information, see "Upper Austria (State of)," published on June 15, 2007, on RatingsDirect.) For a positive rating action, Hypo OÖ would have to demonstrate a stronger-than-expected momentum in noninterest income, a higher net interest margin, a more diversified revenue basis, and a strengthening of its capitalization.
Grandfathered debt ratings: AAA/Negative/A-1+
Hypo OÖ's obligations incurred until April 2, 2003, irrespective of their maturity, will continue to benefit from the state guarantee. Obligations incurred between April 3, 2003, and April 1, 2007, maturing by Sept. 30, 2017, will also continue to benefit from the state guarantee. The negative outlook reflects that the existing deficiency guarantee for the grandfathered obligations of Hypo OÖ does not ensure timely payment. Although Standard & Poor's expects that the European commission will allow timely payment, if certain conditions are met, Standard & Poor's relies on the commitment of the state guarantors to make payments in a timely fashion should this ever become necessary. The commitment of the guarantor might change over time, however, for example, in the case of privatization. Hypo OÖ paid €1.4 million as compensation for the guarantee in 2007 after €1.9 million in 2006).
Profile: A Regional Bank With Strong Ties To The Provincial State
Hypo OÖ is a small regional bank in Upper Austria, which mainly focuses on residential mortgage lending to private individuals and housing associations, public sector lending, and--to a smaller extent--local commercial real-estate developers. Standard & Poor's expects that the expertise in conducting the state's housing promotion ("Eigenheimförderung") program will continue to secure Hypo OÖ's established business model through a stable flow of low risk, but also low-margin, long-term loans. Reflecting the bank's cautious risk strategy, we do not expect Hypo OÖ to directly originate business beyond its well-known home market, which is determined by below-Austrian-average unemployment (3%-4%) and above-average wealth. Nevertheless, Hypo OÖ opportunistically participates in syndications of corporate debt and private public partnership projects. The overall volume of these activities is limited and does not significantly contribute to the bank's overall revenue generation.
Hypo OÖ used the transition period until the abolition of state guarantees for investments aimed at reducing its dependence on interest-related income. Although the bank invested in the expansion of its private banking and asset management unit, the outcome still remains unsatisfactory.
Salzburger Landeshypothekenbank AG (SLHYP)
Hypo OÖ holds 25% of neighboring Salzburger Landeshypothekenbank AG, in which RLB OÖ maintains a majority stake. The acquisition was motivated by intentions to strengthen market shares and to exploit synergies based on the close economic links between the states of Salzburg and Upper Austria. However, we do not expect this participation to generate a meaningful dividend for Hypo OÖ.
Support And Ownership: Strong Ties To The State--Implicit Support
The State of Upper Austria holds a majority stake (50.6%) in Hypo OÖ. RLB OÖ, its strategic minority shareholder, has pooled its stake together with two other investors in a holding company. (For a detailed overview of the ownership structure, see chart below.) Hypo OÖ operates in the form of a joint-stock company (Aktiengesellschaft).
Standard & Poor's does not expect a reduction of the State of Upper Austria's stake in Hypo OÖ in the foreseeable future given their cooperation in terms of real-estate promotion activities and the state's sound financial profile.
Even in the unlikely case of a reduction of the state's ownership of Hypo OÖ, Standard & Poor's expects the state's willingness and ability to continue to guarantee all debt outstanding covered by the deficiency guarantee.
Strategy: Low Risk And Low Margin In A Highly Competitive Environment
Standard & Poor's considers Hypo OÖ's risk aware strategy to be adequate. Due to its long-established relationship with the state and intimate knowledge of the local market, we expect the bank to benefit from a stable inflow of low-risk business from both residential mortgage and public sector lending.
However, determined by its limited expansion we remain reluctant concerning Hypo OÖ's ability to significantly increase its market share in higher margin services such as asset management and private banking. This is due to its underdeveloped brand compared with larger or more specialized domestic players in this segment.
The low risk profile is supported by its ability to issue Pfandbriefe. Furthermore, we expect customer deposits to remain a stable source of funding for a foreseeable future as long as the state holds the majority stake in the bank.
The areas of cooperation with RLB OÖ will remain limited due to RLB's already very high market share in retail banking in the State of Upper Austria. Both banks work together in areas that do not directly affect its customers, such as back-office activities, treasury, and credit risk management. The main benefits emerging from this cooperation for Hypo OÖ are quality improvements on important projects. However, the chosen two-brand strategy clearly limits further cost-savings potential. Hypo OÖ follows a niche strategy to compete with 102 primary banks belonging to RLB OÖ, thereby additionally limiting a higher level of integration. RLB OÖ is one of nine regional banks in the three-Tier Austrian Raiffeisen sector (cooperative banks), which is headed by the sector's central institution Raiffeisen Zentralbank Oesterreich (A+/Stable/A-1).
Risk Profile And Management: Focus Remains To Be Collateralized Mortgage And Public Sector Lending
Hypo OÖ's risk profile is dominated by collateralized loans. Wholesale lending via syndications and small and midsize enterprise (SME) financing is of limited importance for Hypo OÖ's risk profile. The treasury department opportunistically takes interest rate risk and has been an important contributor to the overall profitability. Hypo OÖ's fixed income securities investments are mainly managed by a third-party investment manager (Kepler). Risk related to trading activities is almost nonexistent.
Enterprise risk management
Standard & Poor's regards Hypo OÖ's risk management as adequate in light of the bank's risk-taking capabilities. However, we will be concerned if Hypo OÖ decides to take risks on other areas without adequate improvements to the bank's current systems. Stress-testing procedures related to interest rate risk reflect regulatory requirements supplemented by own scenarios to determine interest rate volatility on the bank's profit and loss. Management is sufficiently and regularly informed about the bank's utilization of risk limits. Hypo OÖ implemented the standardized measurement method for assessing market and operational risk, and is expected to further gradually improve risk management procedures in cooperation with RLB OÖ.
Credit risk
Credit risk is the main source of risk for Hypo OÖ and consequently consumes the bulk of Hypo OÖ's overall risk based on an expected loss model. Hypo OÖ's asset quality is regarded as sound, and stronger than that of most Landeshypothekenbank peers. It benefits from a high proportion of low risk and granular residential real-estate loans in a relatively stable regional property market and public-sector lending. As a result, credit-loss provisioning requirements have remained at a low level compared with peers.
Table 1
Credit Loss Provisions
2003
2004
2005
2006
2007
Gross loans (mil. €)
3461
3683
3802
3993
4321
Credit loss provisions (CLP) (mil. €)
7
6.68
5.52
5.91
3.75
CLP/gross loans (bps)
20
18
15
15
9
bps--Basis points.
Continued sound underwriting standards and the focus on core customer groups are expected to ensure asset-quality measures in the future. Exposure to corporate loans via syndications will gradually increase, but we expect the risk to be manageable.
Although the bank's real-estate exposures include sizable loans to developers, they do not affect the bank's risk profile negatively. These are in general related to subsidized residential real-estate projects located in Upper Austria, where Hypo OÖ has an intimate knowledge of the property market and is emphasized by a history of no actual defaults. Hypo OÖ's nonmortgage loan portfolio is generally well diversified, with some weighting toward the medical sector in addition to regional SMEs, and retail customers. The securities portfolio basically consists of third-party managed fixed-income fund investments and fixed-income securities issued by Western European sovereigns and banks.
Market risk
The most important market risk for Hypo OÖ is the interest rate risk of its banking book. The key risk arises from the basis mismatch between its floating-rate mortgage loans (linked to an average yield of listed bonds) and floating-rate liabilities (linked to EURIBOR). In 2007, the bank reported a reduced impact on equity assuming a 200 basis point shift in interest rates (€3.6 million after €32.2 million in 2006) reflecting the reduced market risk sensitivity. Aggregated value at risk (VAR) of €9.2 million (€14.4 million in 2006) reflects the conservative management approach.
The bank's trading operations are generally client driven and risk taking is usually low, both in absolute terms and considering its limits. In its trading book, Hypo OÖ does not typically engage in own-account position taking, but invests in managed equity and fixed-income funds managed by KEPLER Kapitalanlage GmbH (not rated). The bank's investments into asset-backed securities funds and related structures of €0.1 billion resulted in some minor impairment charges, which are not seen as critical. There is no impact from write-downs on subprime assets. Hypo OÖ is not active in conduit financing or other off-balance-sheet structures.
Funding and liquidity risk
The impact on funding costs and liquidity from the loss of state guarantees is regarded as manageable for Hypo OÖ due to the bank's ability to issue covered bonds, and a stable share of customer deposits. Like other Landeshypothekenbanks, Hypo OÖ used the transition period to prefund future business. Therefore, we expect the general impact on the funding costs to be delayed.
Profitability: Low Operating Profitability: Enhanced By Income From Investments
Hypo OÖ's low profitability is regarded as the bank's key weakness. Higher profitability levels are predominantly limited by the bank's position as a state related bank (focus on public sector and residential mortgage lending) and its close relation to RLB OÖ (limited room to expand into retail business) leading to a high dependence on interest income further aggravated by an environment of steadily decreasing interest margins. Driven by the inverse yield curve during 2007, net interest spread plunged to 45 basis points at year-end 2007, from 79 basis points in 2006.
Profitability remains to be highly sensitive to changes in income from companies consolidated at equity (including SLHYP), which account for 61% of the pretax profit at the end of Dec. 31, 2007. This is viewed as critical as even from the cost side we see some pressure with cost-to-income ratio reaching a level of 66%, which is far weaker than peers.
Table 2
Pretax Profit Generation
(Mil. €)
2006
% of total
2007
% of total
Change 2007 vs. 2006
Corporates
2.0
5.45
5.4
21.69
170.00
Retail/mortgage financing
1.2
3.27
4.0
16.06
233.33
Financial market (excl. at equity)
16.9
46.05
3.7
14.86
(78.11)
Income from investments (at equity)
18.8
51.23
15.3
61.45
(18.62)
Other
(2.2)
(5.99)
(3.5)
(14.06)
59.09
Total pretax profit
36.7
100.00
24.9
100.00
(32.15)
Total pretax profit (excl. at equity)
17.9
48.77
9.6
38.55
(46.37)
We consider that 2007 was extraordinary for Hypo OÖ due to the unfavorable yield curve, however, Standard & Poor's expects the first half of 2008 to be difficult as well. Going forward, the bank needs to intensify the cooperation with RLB OÖ to reduce costs and strengthen its efforts to increase revenue generation to allow the business model to be successful going forward.
We see the prudent underwriting criteria and sound credit quality, resulting in generally low provisioning needs, as the key mitigating factor in an unforeseen sudden stress test.
Capital
Standard & Poor's regards Hypo OÖ's capitalization as low, despite its moderate risk profile. This assessment takes into account that a substantial part of capital is allocated to the stake in SLHYP, which Hypo OÖ consolidates at equity. Standard & Poor's fully deducts the book value of the stake from ATE to take into account the potential double-leverage effect and concentration risk.
Even though the profitability of the bank is regarded as low, it continuously builds up capital by retaining earnings.
At Dec. 31, 2007, Hypo OÖ reported an ATE of €198 million or 5.62% of risk assets, according to Standard & Poor's definition of capital. Given Hypo OÖ's asset composition focusing on residential mortgage and public sector lending, Standard & Poor's expects that the additional requirements for operational risks under Basel II are more than offset by the reduced needs of its loan portfolio. Hypo OÖ will follow the standardized approach.
Table 3
Balance Sheet Statistics
--Year ended Dec. 31--
Breakdown as a % of assets (adj.)
(Mil. €)
2007*
2006
2005
2004
2003
-
2007*
2006
2005
2004
2003
Assets
Cash and money market instruments
828.79
794.38
663.00
631.03
586.55
10.62
11.85
11.33
11.43
11.58
Securities
1652.92
1078.92
821.91
727.21
607.80
21.19
16.09
14.04
13.17
12.00
Trading securities (marked to market)
161.08
0.00
0.00
0.00
N.A.
2.06
0.00
0.00
0.00
N.A.
Nontrading securities
1491.84
1078.92
821.91
727.21
607.80
19.12
16.09
14.04
13.17
12.00
Loans to banks (net)
858.13
809.06
537.34
453.39
380.36
11.00
12.07
9.18
8.21
7.51
Customer loans (gross)
4321.68
3956.98
3766.22
3652.78
3434.77
55.40
59.03
64.35
66.15
67.82
Public sector/government
482.54
N.A.
N.A.
N.A.
N.A.
6.19
N.A.
N.A.
N.A.
N.A.
Residential real estate loans
2405.63
N.A.
N.A.
N.A.
N.A.
30.84
N.A.
N.A.
N.A.
N.A.
All other loans
1433.51
3956.98
3766.22
3652.78
3434.77
18.37
59.03
64.35
66.15
67.82
Loan loss reserves
38.85
0.00
0.00
0.00
0.00
0.50
0.00
0.00
0.00
0.00
Customer loans (net)
4282.83
3956.98
3766.22
3652.78
3434.77
54.90
59.03
64.35
66.15
67.82
Earning assets
7624.24
6611.39
5767.93
5437.85
4991.14
97.73
98.62
98.56
98.47
98.55
Equity interests/participations (nonfinancial)
66.56
15.53
12.38
12.06
7.99
0.85
0.23
0.21
0.22
0.16
Inv. in unconsolidated subsidiaries (financial co.)
