vorarlberger landes- und hypothekenbank - hypo …s investors service financial institutions key...

FINANCIAL INSTITUTIONS

CREDIT OPINION29 May 2017

Update

RATINGS

Vorarlberger Landes- undHypothekenbank AGDomicile Austria

Long Term Debt Baa1

Type Senior Unsecured - FgnCurr

Outlook Stable

Long Term Deposit Baa1

Type LT Bank Deposits - FgnCurr

Outlook Stable

Please see the ratings section at the end of this reportfor more information. The ratings and outlook shownreflect information as of the publication date.

Contacts

Bernhard Held, CFA 49-69-70730-973VP – Senior [email protected]

Alexander Hendricks,CFA

49-69-70730-779

Associate ManagingDirector - [email protected]

Carola Schuler 49-69-70730-766Managing Director [email protected]

Vorarlberger Landes- und HypothekenbankAGSemiannual Update

Summary Rating RationaleWe assign Baa1/P-2 debt, issuer and deposit ratings to Vorarlberger Landes- undHypothekenbank AG (VLH), we also assign backed A3/P-2 debt and deposit ratings to VLH;these ratings carry a stable outlook. In addition, we assign A3(cr)/P-2(cr) Counterparty Risk(CR) Assessments to VLH, and we rate its Subordinate MTN program rating (P)Ba1.

VLH's Baa1 long-term debt and deposit ratings reflect (1) the bank's baa3 BCA and AdjustedBCA; and (2) the results of our Loss Given Failure (LGF) analysis, which takes into accountthe severity of loss faced by different liability classes in resolution, and which results in twonotches of rating uplift for VLH's debt and deposit ratings.

VLH’s baa3 BCA reflects (1) the bank’s improved asset risk profile following the exchangeof its exposure to Heta Asset Resolution AG (Heta, Ca stable)1 into sovereign-guaranteedbonds; (2) the bank’s sound, though likely declining earnings generation capacity and itsimproving capital ratios; and (3) the bank’s ability to tap various funding sources to refinanceits concentrated debt maturities.

Exhibit 1

Rating Scorecard - Key Financial Ratios

4.5% 13.9%

0.5%

39.4% 15.3%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

0%

2%

4%

6%

8%

10%

12%

14%

16%

Asset Risk:Problem Loans/

Gross Loans

Capital:Tangible Common

Equity/Risk-WeightedAssets

Profitability:Net Income/

Tangible Assets

Funding Structure:Market Funds/

Tangible BankingAssets

Liquid Resources:Liquid Banking

Assets/TangibleBanking Assets

Solvency Factors (LHS) Liquidity Factors (RHS)

VLH (BCA: baa3) Median baa3-rated banks

So

lve

ncy F

acto

rs

Liq

uid

ity F

acto

rs

Source:Moody's Financial Metrics, Asset risk and Profitability show 3-year averages

https://www.surveygizmo.com/s3/1133212/Rate-this-research?pubid=PBC_1069722

MOODY'S INVESTORS SERVICE FINANCIAL INSTITUTIONS

Credit Strengths

» Above-average operating earnings compared with moderate domestic bank industry profits

» Improving capital ratios, which we expect to further strengthen in line with regulatory requirements

» LGF analysis indicates a very low loss-given-failure for deposits and senior unsecured debt, providing two notches of rating uplift toVLH's long-term ratings

Credit Challenges

» The low interest rate environment and intense competition in key Austrian lending segments weigh on the bank’s net interestincome

» VLH remains engaged in a process of re-shaping its liability structure

Rating Outlook

» The outlook on VLH's Baa1 long-term debt and deposit ratings and on its A3 backed long-term debt and deposit ratings is stable,reflecting both reduced solvency and liquidity risks, but also some profitability headwinds.

Factors that Could Lead to an Upgrade

» An upgrade of VLH's long-term ratings could result from (1) an upgrade of its BCA; and/or (2) greater rating uplift as result of ourAdvanced LGF analysis.

» VLH's BCA could be upgraded based on a combination of improved capital levels and the successful implementation of a long-termsustainable funding structure. A future upgrade of VLH's long-term ratings would most likely be driven by an upgrade of the bank'sBCA.

» Our Advanced LGF analysis could result in one additional notch of rating uplift if VLH issues significant volumes of subordinateddebt instruments.

Factors that Could Lead to a Downgrade

» A downgrade of VLH's long-term ratings could be triggered following (1) a lowering in the bank's standalone BCA; and/or (2) anincrease in the expected loss severity following a material shift in the bank's funding mix, as part of its ongoing refinancing ofdeficiency-guaranteed debt maturities primarily with covered bond issuance, which could result in less rating uplift for senior debtsas a result of our LGF analysis.

» Our Advanced LGF analysis would likely result in fewer notches of rating uplift, in particular if the overwhelming part of VLH'smaturing senior unsecured instruments are replaced with secured debt instruments.

» A downgrade of VLH's standalone BCA could be triggered if the bank faced asset quality pressures for instance related to itsventure capital investment and at the same time failed to maintain an earnings profile superior to domestic peers, e.g. if risingfunding costs and declining lending margins were to pressure the bank’s net interest income.

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 29 May 2017 Vorarlberger Landes- und Hypothekenbank AG: Semiannual Update


Key Indicators

Exhibit 2

Vorarlberger Landes- und Hypothekenbank AG (Consolidated Financials) [1]12-162 12-152 12-142 12-133 12-123 CAGR/Avg.4

Total Assets (EUR billion) 13 14 14 14 14 -2.55

Total Assets (USD billion) 14 15 17 19 19 -7.85

Tangible Common Equity (EUR billion) 1.1 0.9 0.9 0.8 0.8 8.55

Tangible Common Equity (USD billion) 1.1 1.0 1.0 1.1 1.0 2.65

Problem Loans / Gross Loans (%) 3.2 5.9 4.4 4.8 2.7 4.26

Tangible Common Equity / Risk Weighted Assets (%) 13.9 12.0 10.5 10.7 9.5 12.27

Problem Loans / (Tangible Common Equity + Loan Loss Reserve) (%) 27.0 51.4 41.2 44.5 27.5 38.36

Net Interest Margin (%) 1.3 1.3 1.3 1.2 1.2 1.36

PPI / Average RWA (%) 1.2 1.6 1.7 1.7 2.1 1.57

Net Income / Tangible Assets (%) 0.6 0.6 0.3 0.5 0.7 0.56

Cost / Income Ratio (%) 63.5 50.4 47.9 47.2 39.3 49.76

Market Funds / Tangible Banking Assets (%) 39.4 45.0 50.9 50.4 53.6 47.96

Liquid Banking Assets / Tangible Banking Assets (%) 15.3 18.0 17.7 20.5 18.5 18.06

Gross Loans / Due to Customers (%) 181.9 194.7 207.5 190.5 198.0 194.56

[1] All figures and ratios are adjusted using Moody's standard adjustments [2] Basel III - fully-loaded or transitional phase-in; IFRS [3] Basel II; IFRS [4] May include rounding differences dueto scale of reported amounts [5] Compound Annual Growth Rate (%) based on time period presented for the latest accounting regime [6] Simple average of periods presented for the latestaccounting regime. [7] Simple average of Basel III periods presentedSource: Moody's Financial Metrics

Detailed Rating ConsiderationsImproving capital ratios, which we expect to further strengthen in line with regulatory requirementsBased on the recent years' track record of earnings retention and VLH's commitment to strengthen capital, we believe VLH will furtherraise its regulatory capital ratios and the Tangible Common Equity ratio, our key capital metric, during 2017. The pace of capitalaccretion will however slow down compared to 2016 in the absence of similar one-off effects and as VLH's operating profitability willlikely stabilise at a lower level. Beyond earnings-retention, the bank has implemented several measures that have helped it to offsetfuture upward pressure that may arise on its risk-weighted asset base as a result of tighter regulatory risk-measurement requirementsthat we expect would affect VLH less than entities that employ internal models to calculate risk-weighted assets.

As of 31 December 2016, VLH improved its capital buffer to absorb potential losses in a stressed economic environment, with atransitional Common Equity Tier 1 (CET1) ratio of 13.2% and €1.0 billion CET1 capital under IFRS (December 2015: 11.2%, €874.8million). VLH's strengthened capital base benefited from its sound earnings capacity, which translated into a reported net income of€88.4 million (2015: €93.0 million), which was affected by several one-off items. At end-2016, the bank's regulatory CET1 leverageratio of 6.2% remained at a good level compared with domestic peers.

Above-average operating earnings compared to moderate domestic bank industry profitsWe expect VLH's net profitability to remain strong compared with local peers, although in an international context its earnings-generation capacity is moderate. The bank's historic net income generation of 0.5% of tangible assets is likely to come under somepressure going forward, owing to (1) margin pressure resulting from the low interest rate environment; and (2) rising funding costs uponthe refinancing of the bank's concentrated debt maturities.

In 2016, VLH's reported cost-income ratio slid to 55.3% from 45.3% in 2015. Extraordinary items affected VLH's income from2014 through 2016. In 2014, the bank created a provision of €36.0 million to reflect the risks of the later provided liquidity forPfandbriefbank (Oesterreich) AG (Pfandbriefbank, Baa3 stable).2 The resolution of Heta's debt crisis contributes a positive one-off effectto VLH's 2016 results as the distressed debt exchange completed in October 2016 resulted in a recovery of 90% of VLH's claim.



Heta solution has helped reduce asset risk whereas venture capital poses new risksFollowing the divestment of VLH's Heta exposure, VLH benefits from an improved asset risk profile within which the bank's real-estateand Italian lending activities (17% and 10%, respectively, of VLH's client receivables as of December 2016) carry higher credit risksthan its domestic retail and corporate/small and medium-sized enterprises lending activities. In addition, VLH's investment in venturecapital / private equity fund Hypo EQUITY Unternehmensbeteiligungen AG (HUBAG) represents a material impairment risk for thebank in 2017.

In 2016, VLH's non-performing loans ratio declined to 3.2% from 5.9%, foremost due to the replacement of the bank's exposure toHeta with Sovereign-guaranteed debt issued by Kaerntner Ausgleichszahlungs-Fonds (KAF, Aa1 stable)3 worth 90% of the original Hetaclaim leads to a windfall profit related to the recovery of provisions that had been as high as 50% as of 31 December 2015.

VLH's 2016 results and non-performing loan ratios do not include the bank's at-equity stake in HUBAG, which according to thebank could require a markdown by €30.4 million in a worst case scenario in 2017. VLH has also handed out €24.0 million of loans toHUBAG, which the bank considers well-covered by HUBAG's assets, but which would add to its €312 million of impaired loans the bankreports as of 31 December 2016.

Domiciled in the western-most Austrian state bordering Switzerland, VLH has been lending in foreign currency, particularly CHF tocommuters earning CHF-salaries, and in Switzerland, through its St. Gallen based subsidiary. The bank's total CHF-denominated loansaccounted for a shrinking 18.2% of VLH's client receivables as of December 2016 (2015: 19.6%).

Vorarlberg is a small Austrian region with around 400,000 inhabitants and currently accounts for 66% of VLH's client loans. Wecurrently adjust the bank's asset score down by one notch, to reflect the resulting currency and geographical concentrations.

VLH remains engaged in a process of re-shaping its liability structureWe consider VLH's funding profile to be a relative challenge, because of its high dependence on wholesale funding. In 2017, €2.3billion of 'grandfathered' debt issued by VLH with a deficiency guarantee from the State of Vorarlberg will mature. The bank's liquiditymanagement has already prefunded relatively large volumes of these maturities. Unless investor sentiment deteriorated significantly,we regard the remaining funding challenges as manageable, even though the bank reduced its stock of liquid assets in 2016 to reducethe profitability drag associated with it.

Despite a temporary Heta-related decline in foreign investor confidence towards the broader banking system, VLH has demonstratedgood access to mostly domestic wholesale funding markets, with repeated issuances of covered bond securities complemented by theissuance of senior unsecured and subordinated debt instruments.

Overall, we expect the bank's funding profile to conclude the current adjustment process upon the maturity of the bulk of VLH'sgrandfathered debt in September 2017.

Notching ConsiderationsLoss Given Failure (LGF)VLH is subject to the EU Bank Recovery and Resolution Directive (BRRD), which we consider an Operational Resolution Regime. Asa result, we apply our advanced LGF analysis to VLH's liabilities, considering the risks faced by the different debt and deposit classesacross its liability structure at failure. We assume residual tangible common equity of 3% and losses post-failure of 8% of tangiblebanking assets, a 25% run-off in “junior” wholesale deposits, a 5% run-off in preferred deposits, and assign a 25% probability todeposits being preferred to senior unsecured debt. These ratios are in line with our standard assumptions.

Our LGF analysis indicates a very low loss-given-failure for deposits and senior unsecured debt, leading us to position their PreliminaryRating Assessment two notches above VLH's baa3 Adjusted BCA. The LGF uplift assessment for VLH is supported by the bank'ssubstantial volume of senior unsecured debt, which mainly consists of backed/grandfathered senior debt with sizeable maturities until2017.

Our LGF analysis indicates a high loss-given-failure for VLH's subordinate debt, leading to a positioning one notch below the AdjustedBCA.



Government SupportThe introduction of the BRRD has demonstrated a reduction in the willingness of EU governments to bail-out banks as it severelyrestricts the conditions under which authorities can use public monies to fund a bank recapitalisation. We expect most failing banksto be resolved without governments providing financial support. This approach to support will be broadly consistent throughout theEU, as the BRRD provides little room for national discretion. As a result, we consider the State of Vorarlberg's options considerablylimited going forward. Furthermore, with VLH not being considered an institution of systemic relevance, we do not expect the bankto benefit from government support. Therefore, the bank's senior unsecured debt and deposit ratings of Baa1 do not include any upliftfrom government support.

We assign a “moderate” support probability to instruments that carry a deficiency guarantee provided from the bank's guarantor, theState of Vorarlberg. This leads to positioning those instruments' ratings one notch above VLH's senior unsecured and deposit as wellas its subordinated debt ratings (A3 and Baa3 for senior/deposits and subordinated backed obligations respectively). VLH's A3 backedsenior debt and deposit ratings as well as the bank's Baa3 backed subordinated debt benefit from a deficiency guarantee of the State ofVorarlberg. The support likelihood we attribute to this deficiency guarantee is “moderate”, reflecting the credit implications of Austria'sConstitutional Court's ruling published on 28 July 2015, which inter alia reinstated the deficiency guarantees on subordinated debtissued by Hypo Alpe Adria, the predecessor of Heta. We believe that, as a consequence of the court's ruling, hurdles for retroactivelyvoiding deficiency guarantees in Austria - as also applicable to VLH - have significantly risen. This has led us to attribute some value tothe deficiency guarantee benefitting VLH, thereby placing the respective backed ratings one notch above the bank's senior unsecured aswell as subordinated ratings.

However, the “moderate” support probability also reflects constraints in terms of potential timeliness of payments and the capabilitiesof Vorarlberg as support provider, given the higher weight of deficiency-guaranteed debt relative to Vorarlberg's regional domesticproduct. This also reflects the state's hesitance to participate in a joint support effort for Pfandbriefbank despite their role under astatutory, multi-recourse liability scheme for Pfandbriefbank extending to a number of Austrian Landeshypothekenbanken and theirstatutory federal state guarantors.



Rating Methodology and Scorecard Factors

Exhibit 3

Vorarlberger Landes- und Hypothekenbank AGMacro FactorsWeighted Macro Profile Strong + 100%

Factor HistoricRatio

MacroAdjusted

Score

CreditTrend

Assigned Score Key driver #1 Key driver #2

SolvencyAsset RiskProblem Loans / Gross Loans 4.5% baa1 ← → baa2 Geographical

concentrationNon lending credit risk

CapitalTCE / RWA 13.9% a2 ↑ a2 Expected trend Risk-weighted

capitalisationProfitabilityNet Income / Tangible Assets 0.5% baa2 ↓ ba2 Expected trend

Combined Solvency Score a3 baa2LiquidityFunding StructureMarket Funds / Tangible Banking Assets 39.4% ba2 ↑ ba3 Term structure

Liquid ResourcesLiquid Banking Assets / Tangible Banking Assets 15.3% baa2 ← → baa1 Additional

liquidity resourcesAsset encumbrance

Combined Liquidity Score ba1 ba1Financial Profile baa3

Business Diversification 0Opacity and Complexity 0Corporate Behavior 0

Total Qualitative Adjustments 0Sovereign or Affiliate constraint: Aa1Scorecard Calculated BCA range baa2-ba1Assigned BCA baa3Affiliate Support notching 0Adjusted BCA baa3

Balance Sheet in-scope(EUR million)

% in-scope at-failure(EUR million)

% at-failure

Other liabilities 4,200 32.1% 4,738 36.2%Deposits 5,282 40.4% 4,743 36.3%

Preferred deposits 3,909 29.9% 3,713 28.4%Junior Deposits 1,373 10.5% 1,030 7.9%

Senior unsecured bank debt 2,759 21.1% 2,759 21.1%Dated subordinated bank debt 435 3.3% 435 3.3%Preference shares (bank) 10 0.1% 10 0.1%Equity 392 3.0% 392 3.0%Total Tangible Banking Assets 13,078 100% 13,078 100%



De jure waterfall De facto waterfall NotchingDebt classInstrumentvolume +

Subordination

Sub-ordination

Instrumentvolume +

Subordination

Sub-ordination

De jure De factoLGF

notchingguidance

versusBCA

AssignedLGF

notching

Additionalnotching

PreliminaryRating

Assessment

Counterparty Risk Assessment 35.4% 35.4% 35.4% 35.4% 3 3 3 3 0 a3 (cr)Deposits 35.4% 6.4% 35.4% 27.5% 2 3 2 2 0 baa1Senior unsecured bank debt 35.4% 6.4% 27.5% 6.4% 2 2 2 2 0 baa1Dated subordinated bank debt 6.4% 3.1% 6.4% 3.1% -1 -1 -1 -1 0 ba1

Instrument class Loss GivenFailure notching

AdditionalNotching

Preliminary RatingAssessment

GovernmentSupport notching

Local CurrencyRating

ForeignCurrency

RatingCounterparty Risk Assessment 3 0 a3 (cr) 0 A3 (cr) --Deposits 2 0 baa1 0 Baa1 Baa1Senior unsecured bank debt 2 0 baa1 0 Baa1 Baa1Dated subordinated bank debt -1 0 ba1 0 Ba1 --Source: Moody's Financial Metrics

About Moody's ScorecardOur Scorecard is designed to capture, express and explain in summary form our Rating Committee's judgment. When read inconjunction with our research, a fulsome presentation of our judgment is expressed. As a result, the output of our Scorecardmay materially differ from that suggested by raw data alone (though it has been calibrated to avoid the frequent need for strongdivergence). The Scorecard output and the individual scores are discussed in rating committees and may be adjusted up or down toreflect conditions specific to each rated entity.

Ratings

Exhibit 4Category Moody's RatingVORARLBERGER LANDES- UND HYPOTHEKENBANKAG

Outlook StableBank Deposits Baa1/P-2Bkd Bank Deposits A3/P-2Baseline Credit Assessment baa3Adjusted Baseline Credit Assessment baa3Counterparty Risk Assessment A3(cr)/P-2(cr)Issuer Rating Baa1Senior Unsecured Baa1Subordinate MTN -Dom Curr (P)Ba1ST Issuer Rating P-2

Source: Moody's Investors Service



Endnotes1 The rating shown is Heta's Carinthian state-guaranteed senior unsecured debt rating and outlook

2 The rating shown is Pfandbriefbank's backed senior unsecured debt rating and outlook.

3 The rating shown is KAF's Backed Senior Secured rating and outlook.



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Contacts

Christina GernerAssociate Analyst

Bernhard Held, CFAVP-Senior Analyst

CLIENT SERVICES

Americas 1-212-553-1653

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