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Rating Action:

Moody's assigns first-time Baa1 deposit ratings to Luminor Bank in Estonia; stable outlook

13 Sep 2018

London, 13 September 2018 -- Moody's Investors Service, ("Moody's") has assigned first time ratings to Luminor Bank AS (Estonia) ("Luminor" or "Luminor Estonia"), including long-and short-term foreign- and local--currency deposit ratings of Baa1/P-2, a provisional local currency long-term (P)Baa2 senior MTN rating, and local and foreign currency counterparty risk ratings (CRR) of A3/P-2. Furthermore the bank was assigned a baseline credit assessment (BCA) of ba1, an adjusted BCA of ba1, as well as a counterparty risk assessment of A3(cr)/P-2(cr). The outlook on the long-term deposit ratings is stable.

The ratings assigned to the bank incorporate: 1) the standalone baseline credit assessment (BCA) of ba1, which balances the strong capital levels and unwinding legacy assets against modest profitability weighed down by merger related costs and the ongoing restructuring of its funding profile; 2) the substantial amounts of debt that would absorb losses in case of failure, as indicated by Moody's advanced loss given failure (LGF) analysis, resulting in 1 to 3 notches of uplift for each rated debt class; and 3) a moderate probability of government support for deposits and senior unsecured debt due to the systemic importance of the group, resulting in one additional notch of uplift in the ratings.

Luminor is a recently created merger of Nordea Bank AB (Aa3/Aa3 stable, a3) and DNB Bank ASA's (Aa2/Aa2 negative, a3) operations in the Baltics, with the branch structure still pending. Luminor is also in the process of changing ownership, with majority control to be acquired by a consortium of investors led by Blackstone, a private equity firm, joined also by a wholly-owned subsidiary of the Abu Dhabi Investment Authority. In Moody's opinion, the change in ownership will have limited effects on the bank's strategy and risk appetite during the next 12 to 18 months, with Blackstone supporting the management's efforts to build an independently funded and profitable pan-Baltic bank. While we view the group of owners as providing strong governance and financial backing, the ratings do not benefit from affiliate support uplift given the mid-term investment horizon of private equity firms.

The long term deposit ratings carry a stable outlook, reflecting Moody's view that over the next 12-18 months, the bank will perform in line with forecasts in the context of a benign operating environment, and issue senior unsecured debt according to funding plans.

A full list of the affected ratings can be found at the end of this press release.

RATINGS RATIONALE

DETAILED RATING CONSIDERATIONS

STANDALONE BASELINE CREDIT ASSESSMENT

The ba1 standalone baseline credit assessment (BCA) of the group reflects its strong capitalization, which underpins a solid solvency profile balanced against relatively weak but improving asset risk, modest profitability and a robust but still evolving funding and liquidity profile that the bank's management aims to further strengthen by decreasing dependence on its owners' backing.

Ratings based on a forward looking view, reflecting the consolidated Baltic operations

Although the bank currently operates under three distinct legal entities, the ratings assigned to Luminor Estonia reflect Moody's forward-looking assessment of the group's operations as a whole (Luminor) which, by January 2, 2019, is expected to legally consolidate Luminor Estonia, Luminor Bank AS Latvia (Luminor Latvia), and Luminor Bank AB Lithuania (Luminor Lithuania).

At that time, the Latvian and Lithuanian banks will become branches of the Estonian entity. Nevertheless, we believe that creditors of any one legal entity in the group already broadly benefit from the strength of the obligor as a whole given the financial inter-linkages and interdependences that exist between the three banks, and the relatively short time period until the merger is finalized.

Strong capitalisation balanced against modest profitability and evolving funding profile

The bank's BCA of ba1 is primarily driven by: 1) the bank's strong capitalization, which underpins its solid solvency profile; 2) improving asset risk; 3) modest profitability weighed down by merger related costs; and 4) a still evolving funding and liquidity profile with focus on decreasing dependence on committed liquidity facilities from DNB and Nordea. The ongoing merger will affect earnings due to higher IT and re-organisation costs and limit asset growth as the bank will focus primarily on becoming self-sufficient with respect to funding.

Luminor benefits from a strong capital position, with expected tangible common equity over risk weighted assets of 17.9% at end 2017 on an aggregate basis. Total capital ratios were 17.7% for Estonia, 18.5% for Latvia and 17.1% for Lithuania at end 2017, already well above the regulatory minimum requirements of 12.6%, 12.9% and 13.8% respectively. Luminor is targeting to retain a CET1 of 17% in all three geographies.

With respect to asset risk, Luminor has a well-diversified loan portfolio within its targeted geography and a healthy combination of low risk appetite and robust risk management controls. Nevertheless, it has inherited a relatively high level of legacy non-performing loans (NPL) from the pre-merger operations (which were hit by the global financial crisis), which could weigh on the bank's profitability if growth and economic recovery prove insufficient to recover these problem loans in the near term. In the current context, we expect the bank's asset quality to gradually improve, with a projected NPL ratio declining to below 5% within the next 12-18 months, from 5.67% on an aggregated basis at end-2017 and 7% in recent years (in aggregate, pre-merger).

The change of majority ownership will have limited negative effects on asset risk in Moody's opinion. Rather, Blackstone's commitment to management's strategy to limit asset growth while the bank strengthens its funding profile is positive, reducing incentives to take on additional asset risk.

Luminor's underlying profitability is modest and we expect it to remain challenged over the next 12-18 months, primarily due to merger-related costs. In the medium term, profitability should improve as restructuring costs related to the merger decrease and the bank realizes benefits from the rationalization of its branch network as well as through the re-pricing of its existing portfolio.

We also expect margins to benefit from an expected increase in deposit funding, and operational synergies arising from the merger. Moody's forecasts a return on assets of 0.3% for 2018, gradually increasing to 0.7% by 2020 on an aggregate level.

Due to Luminor's dependence on funding from DNB and Nordea, market funding ratio is high, at 33.4% year-end 2017. We expect market funding to decrease to below 30% during the outlook period due to positive trends in its deposit gathering. Luminor had a loan to deposit ratio of 142% at year-end 2017, which is high in the region, where banks are typically deposit funded. Moody's expects that Luminor has the potential to reach a higher market share in deposits by focusing on its existing customer base who currently hold their deposits with other banks.

Furthermore, Luminor aims to reduce reliance on the EUR 5 billion committed facility provided by Nordea and DNB, initially by issuing senior unsecured debt. When regulation permits, the bank also plans to issue covered bonds which would, according to Moody's expectations, increase the investor base significantly and increase the number of funding sources.

Although the committed facility provides stability to the funding profile, allowing the bank to issue debt at a gradual pace, the ratings assume the bank will repay the entire facility and achieve funding autonomy after three years of operations.

Luminor has negligible exposures to non-resident customers, and management has clearly stated that they will not accept non-resident customers without legitimate businesses due to money laundering-related risks.

AFFILIATE SUPPORT

Moody's assumes a low probability of affiliate support resulting in no uplift from the BCA in the adjusted baseline credit assessment of ba1.

Due to the sale of their majority stake in Luminor, the sellers, DNB and Nordea, are reducing their financial and reputational interlinkages with Luminor.

Due to the lower ownership of Nordea and DNB, which also entails lower capital requirements, as well as reducing financial risks by imposing collateral requirements in the facilities to Luminor provided by these banks, Moody's assesses the affiliate support to be low from these owners. Furthermore, the new owners represented by Blackstone do not result in affiliate uplift because we see a private equity firm as having lower incentives to support the bank in case of need than a majority bank owner with a history of support. We nevertheless view the ownership of Luminor as a source of strategic strength given the expertise of Blackstone with mergers and capital markets funding.

LOSS GIVEN FAILURE

We apply our LGF analysis to Luminor bank because it is subject to an operational resolution regime, the EU Bank Resolution and Recovery Directive, which implies that investors and creditors will assume losses if the bank fails and is taken into resolution. For this analysis, we assume that the bank's equity and losses will stand at 3% and 8% of tangible banking assets, respectively, in a failure scenario. We also assume a 25% run-off of junior wholesale deposits and a 5% run-off in preferred deposits. Moreover, we assign a 25% probability to junior deposits being preferred to senior unsecured debt. These assumptions are in line with our standard assumptions.

In our Loss given failure analysis we include Luminor's consolidated balance sheet in the Baltics, in line with our forward looking view of the merged entity.

Luminor's deposits are likely to face very low loss given failure because of the bank's high volume of junior deposits, meaning that losses would be spread over a large depositor base, and a sizeable cushion of senior debt, which we expect the bank to start issuing during the year. As a result, our Preliminary Rating Assessment includes a two-notch uplift above the bank's Adjusted BCA of ba1.

Luminor's senior debt will face a low loss given failure due to the forecasted amounts of senior debt issued during the year. As the bank continues issuing higher volumes of senior debt and subordinated instruments, the volumes of loss absorbing liabilities will increase, spreading any losses over a larger creditor base, potentially lowering the loss given failure.

GOVERNMENT SUPPORT

Due to the systemic importance of Luminor, with approximately 16% of deposits market share in the Baltics as of year-end 2017, and the operational resolution regime in the Baltics, Moody's assesses the probability of support to be moderate for senior unsecured debt holders, depositors, and counterparty obligations. All three Baltic countries are considered to be operational resolution regimes, having implemented the Banking Recovery and Resolution Directive, which imposes losses on creditors in case of failure. A moderate support is consistent with how Moody's assesses government support in other European Union jurisdictions.

DEPOSIT RATINGS

The deposit ratings incorporate two notches of LGF uplift and one notch from government support from the bank's adjusted BCA of ba1, resulting in a deposit rating of Baa1.

SENIOR RATINGS

The provisional senior MTN ratings incorporate one notch of LGF uplift and one notch of government support from the bank's adjusted BCA of ba1, resulting in a (P)Baa2 rating.

COUNTERPARTY RISK RATINGs (CRRs)

In assigning CRRs to the banks and financial institutions subject to this rating action, Moody's starts with their adjusted Baseline Credit Assessment (BCA) and uses the agency's existing advanced Loss-Given-Failure (LGF) approach that takes into account the level of subordination to CRR liabilities in the institutions' balance sheet and assumes a nominal volume of such liabilities.

Luminor's CRRs are positioned at A3/P-2, incorporating three notches of LGF and one notch of government support.

COUNTERPARTY RISK (CR) ASSESSMENT

CR Assessments are opinions of how counterparty obligations are likely to be treated if a bank fails, and are distinct from debt and deposit ratings in that they (1) consider only the risk of default rather than expected loss, and (2) apply to counterparty obligations and contractual commitments rather than debt or deposit instruments. The CR Assessment is an opinion of the counterparty risk related to a bank's covered bonds, contractual performance obligations (servicing), derivatives (for example, swaps), letters of credit, guarantees and liquidity facilities.

Luminor Group's CR Assessment is positioned at A3(cr)/P-2(cr), four notches above the bank's Adjusted BCA of ba1, due to three notches of uplift from the LGF analysis and one notch of government support.

The main difference with our Advanced LGF approach used to determine instrument ratings is that the CR Assessment captures the probability of default on certain senior obligations rather than expected loss. Therefore, we focus purely on subordination and take no account of the volume of the instrument class.

WHAT COULD CHANGE THE RATING—UP/DOWN

Factors that could lead to an upgrade include: 1) lower levels of problem loans in combination a careful underwriting standards, not expanding into more risky segments or products; and 2) higher recurring profitability, in line with the bank's forecasts; and 3) increased volumes of deposits in line with forecasts. Furthermore, higher than expected issuances of senior unsecured debt could give additional cushion of loss absorption in case of failure and thereby additional uplift according to LGF approach.

Factors that could lead to a downgrade include: 1) higher levels of problem loans, higher than anticipated growth in lending or entry into higher risk segments; or 2) lower recurring profitability; or 3) a worsened liquidity position or failure to access market funding.; or 4) lower issuances of senior unsecured debt than anticipated by Moody's, reducing the cushion of loss absorbing liabilities protecting creditors and depositors in case of failure. Lower assumptions of government support would also lead to a downgrade of senior, deposit and counterparty risk ratings.

LIST OF AFFECTED RATINGS

..Issuer: Luminor Bank AS (Estonia)

Assignments:

.... Adjusted Baseline Credit Assessment, Assigned ba1

.... Baseline Credit Assessment, Assigned ba1

....Long-term Counterparty Risk Assessment, Assigned A3(cr)

....Short-term Counterparty Risk Assessment, Assigned P-2(cr)

....Long-term Counterparty Risk Rating (Local and Foreign Currency), Assigned A3

....Short-term Counterparty Risk Rating (Local and Foreign Currency), Assigned P-2

....Long-term Deposit Rating (Local and Foreign Currency), Assigned Baa1, Stable

....Short-term Deposit Rating (Local and Forign Currency), Assigned P-2

....Senior Unsecured Medium-Term Note Program (Local Currency), Assigned (P)Baa2

Outlook Actions:

....Outlook, Assigned Stable

PRINCIPAL METHODOLOGY

The principal methodology used in these ratings was Banks published in August 2018. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Niclas Boheman
Asst Vice President - Analyst
Financial Institutions Group
Moody's Investors Service Limited, Stockholm Branch
Krejaren 2
Ostermalmstorg 1
Stockholm 114 42
Sweden
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Sean Marion
MD - Financial Institutions
Financial Institutions Group
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Releasing Office:
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
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JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

No Related Data.
© 2018 Moody’s Corporation, Moody’s Investors Service, Inc., Moody’s Analytics, Inc. and/or their licensors and affiliates (collectively, “MOODY’S”). All rights reserved.

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