Cooperative Banking Sector Germany Primary Credit Analyst: Heiko Verhaag, CFA, FRM, Frankfurt + 49 693 399 9215; [email protected] Secondary Contacts: Harm Semder, Frankfurt + 49 693 399 9158; [email protected] Claudio Hantzsche, Frankfurt + 49 693 399 9188; [email protected] Table Of Contents Major Rating Factors Outlook Rationale Related Criteria Related Research WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 26, 2021 1 Cooperative Banking Sector Germany Major Rating Factors Strengths: Issuer Credit Rating • Mutual support among core group members and a comprehensive protection None scheme. • No. 2 market position in German retail banking. • Strong capitalization from high earnings retention and ownership structure that puts stability over payouts. • Franchise-driven stable deposits and sizable surplus liquidity from local cooperative banks. Weaknesses: • Relatively low risk-adjusted profitability by international standards, with margins under increased pressure due to the lower-for-longer interest rate environment. • German cooperative banks' high cost base, partly attributable to the decentralized network. • Increasing competition and margin pressure, particularly in core products, stemming from big tech companies and digital banks. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 26, 2021 2 Cooperative Banking Sector Germany Outlook S&P Global Ratings' negative outlook on the Cooperative Banking Sector Germany, including all core group members, reflects growing economic and industry risks for the German banking market, which the COVID-19 pandemic has accentuated. This puts continued pressure on the sector's risk exposures and risk-adjusted profitability, meaning that we could lower our ratings within the next two years. Downside scenario More specifically, if we revise our anchor for German banks to 'bbb+' from 'a-', we could lower our 'AA-' issuer credit rating (ICR) on the sector's core members, and our related issue ratings on the banks' senior preferred debt, senior subordinated debt, and regulatory capital instruments. This could happen, for example, if we conclude that incumbent German banking groups will suffer increasingly from intensifying competition and a further deterioration in profitability. While more remote, we could, in time, also lower the ratings if the sector's market position deteriorates materially, weakening its risk-adjusted profitability. Upside scenario We could revise our outlook to stable over the next 24 months if downside risks stemming from the COVID-19 pandemic reduce, and economic and industry risk trends for the German banking industry stabilize. For the sector itself, its business model and risk profile would have to remain robust and resilient relative to other German banks or similarly rated international peers. We believe material progress in digitalization and addressing structural weaknesses, such as cost efficiency and below-average market positions in corporate and private banking, remain pivotal to the sector's creditworthiness. Rationale Despite continued uncertainty about the full effect of the pandemic on the German economy, we expect the cooperative banking sector will remain relatively resilient to the COVID-19-induced economic shock. The sector's strong domestic bias, together with significant government and regulatory support measures has helped mitigate the pandemic's impact on sector credit losses and profitability in 2020. Although we expect the phase-out of government support programs, and that insolvency filings will fully resume in 2021, we expect the sector's asset quality will hold up relatively well. We also expect only a moderate impact on its profitability, easing any risk of a marked deterioration in its capitalization. Nevertheless, our negative outlook reflects ongoing pressure on the German banking industry as a whole to transform business models in a low-for-longer economic environment marked by increasing competitive pressure. In addition, economic implications from the COVID-19 pandemic might pressure the industry's risk-adjusted profitability, leading to lasting damage to the German banking system's resilience. We generally expect the sector will maintain leading business position as the second-largest financial services group in Germany, and one of the largest in Europe, which is a key strength. Additionally, we see an increase in digitalization efforts, albeit lagging those of peers, focusing on efficiency gains and customer value. Ongoing consolidation within the sector should remove inefficiencies and defend the sector's leading position in German retail and small and medium enterprise (SME) banking. However, strong competition from incumbent banks and new competitors, including big WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 26, 2021 3 Cooperative Banking Sector Germany techs and digital banks, could lead to gradual erosion of the sector's competitive strength. In our view, the sector's relatively resilient and solid earnings and generally low dividend payouts through the economic cycle will continue to support its strong capitalization by global standards. We also view positively the combined strength of the sector's a funding profile, which is built on a dominant retail deposit franchise, and its well-managed and sizable surplus liquidity. Anchor:'a-', reflecting the German cooperative banking sector's main operations in Germany's diverse and resilient economy Our bank criteria use our Banking Industry Country Risk Assessment (BICRA) economic risk and industry risk scores to determine a bank's anchor, the starting point in assigning an ICR. Our anchor for banks operating mainly in Germany is 'a-'. Our economic risk assessment considers Germany's highly diverse and competitive economy, with a demonstrated ability to absorb economic and financial shocks. For 2020, we expect German real GDP will have contracted by 5.6%, likely compensated by a strong rebound of 3.7% growth in 2021 and 3.2% in 2022. We note the damage to the economy, household wealth, and various corporate sectors caused by the COVID-19 pandemic, but anticipate that Germany's ample fiscal and monetary measures will mitigate the cyclical shock to the economy, the banking system, and retail and corporate customers, as well as limit German banks' credit losses. That said, the high degree of openness, with exports accounting for 50% of GDP, makes the trajectory of recovery dependent on broad-based international developments. Reviving housing demand and sector-specific challenges, for example in the automotive industry, will also continue to represent a risk to growth after the pandemic has subsided. Our negative economic risk trend signals the possibility that a weaker recovery could drive higher credit losses than we currently expect. Our assessment of industry risk considers material improvements in transparency and in harmonizing banking supervision and regulation. However, we note that German banks entered the crisis with their profitability under pressure due to intense competition, low interest rates, and a relatively high cost base. Challenges to profitability could further intensify as a result of COVID-19 pressure, reflected in our negative industry risk trend. In addition to an expected increase in risk costs, albeit manageable, we anticipate cost pressure will also stem from necessary investments in improving core banking systems and digital customer services. These are essential to avoid tech disruption and franchise damage from cyber-attacks and customer data mismanagement. Table 1 Cooperative Banking Sector Germany--Key Figures --Fiscal year ended Dec. 31-- (Mil. €) 2019 2018 2017 2016 2015 Adjusted assets 1,270,793.0 1,192,712.0 1,147,364.0 1,125,864.0 1,079,344.0 Customer loans (gross) 844,552.0 794,916.0 761,880.0 733,155.0 700,608.0 Adjusted common equity 102,705.0 96,787.0 94,730.0 88,947.0 89,232.4 Operating revenues 29,742.0 26,739.0 28,245.0 27,666.0 28,089.0 Noninterest expenses 18,731.0 18,817.0 18,753.0 18,836.0 18,228.0 Core earnings 7,046.0 5,402.0 6,073.0 5,898.0 6,967.0 WWW.STANDARDANDPOORS.COM/RATINGSDIRECT FEBRUARY 26, 2021 4 Cooperative Banking Sector Germany Business position: Leading retail position in German markets We expect the sector will maintain its leading business position as the second-largest financial services group in Germany, with 825 member banks (as of end 2020) owned by 18 million members and servicing more than 30 million customers in the country. We anticipate that member banks will gradually expand their business volumes, drawing on their robust positions in domestic retail banking, and their strong diversification. We acknowledge the sector's increased digitalization efforts to improve efficiency as positive, however we also believe the sector lags many of its peers with regards to digital banking products. The sector will need to defend its profitability level, which, despite the sector's strong market position, is only average by international standards (chart 1). Additionally, we expect the economic fallout of the COVID-19 pandemic will pressure margins until at least 2023. Accordingly, we expect that the earnings of the local cooperative banks, which heavily depend on interest rates and plain vanilla products, will remain under pressure from continuously low net interest margins. However, we note as positive that cooperative banks prioritize long-term stability over short-term returns. Similarly, we believe the sector could reduce the efficiency gap with the top-100 European banks. We forecast