DBRS Comments on KBC’s 2Q12 Results; Senior at “A”, Trend Stable

DBRS, Inc. (DBRS) has today commented on KBC Group N.V.’s (KBC or the Group) 2Q12 results. DBRS rates KBC’s Senior Long-Term Debt & Deposits at “A” and KBC Bank’s Senior Long-Term Debt & Deposits at A (high). The trend for these ratings is Stable. These ratings reflect KBC’s designation as a Critically Important Banking organisation (CIB) in Belgium. CIBs benefit from DBRS’s rating floor of A (high) for banks and “A” for bank holding companies with short-term ratings of R-1 (middle). These floor ratings inherently have Stable trends.

While results held up well in its Central & Eastern Europe (CEE) business unit with growth in loans and stable cost of risk, this was nevertheless a weak quarter for KBC in a difficult environment. This weakness reflected lower contribution from its Belgian businesses unit, small losses in Merchant Banking (MB), which continued to be impacted by rising impairments in its Irish operations although at a slower pace than previous quarters. Overall, KBC reported net losses attributable to equity holders of the parent of EUR -539 million in 2Q12, as compared to a gain of EUR 333 million in 2Q11 and EUR 380 million in 1Q12.

One-off items drove losses after tax of EUR 911 million, the bulk of which reflected EUR 868 million losses on divestments largely related to impairment charges on goodwill. The sale of its Polish insurance company WARTA somewhat compensated for this negative impact, as it contributed to net profits by about EUR 300 million. The negative impact of the valuation of the Group’s CDO portfolio, and mark-to-market effects on derivatives and other one-time items (of which a EUR 41 million gain on its own debt) were marginal in 2Q12 as opposed to 1Q12. Excluding one-off items, KBC posted a positive net income on an underlying basis of EUR 372 million in 2Q12, below EUR 455 million the previous quarter, and EUR 528 million in 2Q11, bearing in mind the Group’s perimeter changed with the completion of its divestment program.

While KBC continues to benefit from the strength of its core franchise in Belgium and in its core CEE countries (particularly Czech Republic, which accounts for about 66% of its CEE loan book), results for 2Q12 somewhat contracted in Belgium. At the same time, the volatility in KBC’s overall earnings continued to reflect certain weaknesses in its Merchant Banking business unit, primarily driven by the elevated provisioning in KBC Bank Ireland, but also higher senior debt costs.

Underpinning KBC’s ratings is its strength in Belgium where the Group maintains a dominant position, particularly within the wealthy region of Flanders. Competition for deposits is fierce in Belgium. Nonetheless, deposits at KBC were up 5% quarter-over-quarter (QoQ) and year-over-year (YoY), as KBC reported a shift by its customers from asset management products towards deposits. KBC also grew its loan book in Belgium by 2% YoY, driven by mortgages. Commercial margins in Belgium appear not to be under pressure. However, NIM dropped to 1.28% in 2Q12, from 1.42% in 2Q11 and 1.43% in 1Q12, principally reflecting higher average balances with the ECB as well as reduced GIIPS exposure. On an underlying basis, net profit contribution in KBC’s Belgium business unit was negatively impacted by lower contribution from its insurance operations that had lower life insurance products sales reflecting a shift from non-unit linked to unit-linked sales. The insurance contribution fell to EUR 68 million in 2Q12 from EUR 128 million in 1Q12, and EUR 92 million in 2Q11.On the other hand, its banking operations posted EUR 159 million underlying net profit, up from EUR 147 million in 2Q11 and EUR 137 million in 1Q12.

Results for CEE in 2Q12 demonstrated the benefits CEE brings in diversity and growth opportunities to KBC’s core franchise, although CEE also contributes to higher risk levels, given the potential for significant deterioration in these economies, as demonstrated by Hungary in 2011. Indicative of the benefits, net interest margin in the CEE business line remains higher than in Belgium. In 2Q12, provisioning declined driven by a more stable environment in Hungary, as compared to the end of 2011. The Czech Republic remains the main driver of CEE’s profits, with EUR 158 million in 2Q12 net income relative to EUR 188 million for the whole division. Overall, KBC’s loan book in CEE grew 4% YoY. Total deposits were up 3% YoY. In particular, in the Czech Republic, KBC grew loans +12% YoY), while deposit growth recovered in 2Q12 relative to 1Q12 up 4% YoY). Growth in loans in the Czech Republic and in Slovakia reflected growth in mortgages YoY, but this was partly offset by a decline in loans in Hungary and Bulgaria in the same period.

After slightly recovering in 1Q12 with a provisioning reversal, Merchant Banking (MB) posted net losses again in 2Q12. Even excluding KBC Bank Ireland, 2Q12 underlying net profit from Corporate Banking would be a loss of EUR 18 million. Net profit from Market Activities were positive, but declining due to adverse market conditions and were not enough to compensate for losses in Corporate Banking. Following the increased cost of funding, the core business net interest income in Commercial Banking declined to EUR 125 million in 2Q12, down from EUR 167 million in 2Q11 and EUR 148 million in 1Q12. DBRS views positively that the Group is reducing its non-core business activities within MB.

For the banking business, the cost-to-income ratio on an underlying basis improved to 58% year-to-date from 60% in 2011. Expenses declined by 1% YoY, but excluding one-time items, underlying expenses rose by 1% YoY, driven mostly by the impact of inflation on wages in Belgium.

The jump in the Group’s provisioning under IFRS mainly reflects deterioration in certain CEE economies where KBC is engaged in divesting by the end of 2013. Impairments were EUR 1,473 million in 2Q12, a peak relative to past provisioning of EUR 273 million in 1Q12, 746 million in 4Q11, and EUR 940 million in 3Q11. This level is principally impacted by EUR 1.2 billion impairment charges after-tax, which refers to the remaining divestment entities: ZAO Absolut Bank in Russia, Nova Ljubljanska Banka in Slovenia, KBC Banka in Serbia, but also KBC Bank Deutschland in Germany, and Belgium's Antwerp Diamond Bank. Still contributing to elevated impairments in 2Q12 as in the past quarters, is the ongoing stress in Ireland. For the Group overall in 2Q12, total group impairments were higher than its income before provisions and taxes (IBPT), as in 3Q11, but a reversal from 1Q12, when provisions absorbed just 38% of IBPT (and 44.4% in 2Q11). In DBRS’s view, KBC bears the burden of being a restructuring bank, as demonstrated by the finalisation of its divestments program (EC plan). In a weakened environment, this divestment process weighs on both the Group’s IBPT and impairment levels. It is yet to be seen to what extent this divestment process will impact KBC’s underlying earnings.

KBC’s overall non-performing loan (NPL) ratio is elevated. Now at 5.3%, up from 4.9% in 4Q11, the NPL ratio is 100 basis points (bps) above the 2Q11 level, 160 bps above the 2Q10, and 250 bps above the 2Q09 level at the beginning of the crisis, driven primarily by the MB business unit. In CEE, the NPL ratio of 5.6% stabilised since 3Q10, though this ratio is 250 bps above the 2Q09 level. But, in MB, the NPL ratio is now at a high level of 9.5%, jumping from 7.8% in 4Q11, 6.4% in 2Q11 4.1% in 2Q10, and 3.3% in 2Q09, driven by Ireland where the Group registers high levels of impairment as anticipated. While the pace of deterioration appear to have slowed in Ireland, the NPL ratio there nonetheless reached a new high, reaching 21.4% in 2Q12 relative to 20.5% in 1Q12, and 13.2% in 2Q11.

DBRS views KBC’s funding profile as steadily strengthening. The Group maintained its deposits in its core customer segment at EUR 163.7 billion at end-June 2012, and improved its loan-to-deposit ratio to 83% at KBC Bank as compared to 94% in 4Q11. Funding from customer generally represents roughly 70% of total funding largely unchanged from 69% in 2011. KBC has an unencumbered liquid asset buffer of EUR 38.9 billion up from EUR 33.8 billion at end-2011. Deposits at Central banks of EUR 6.1 billion were back to the level of EUR 6.1 billion at end-2011, These resources combined are well above the Bank’s net short-term needs of EUR 24.1 billion. Group’s medium- and long-term (MLT) refinancing needs for 2012 of estimated EUR 15 billion in 1Q12 are covered – but deleveraging reduces KBC’s need for wholesale funding. Senior unsecured debt issued in 2012 represented EUR 2.25 billion year-to-date. Positively, the Group’s CEE subsidiaries have higher deposits than loans (loan-to-deposit ratio of 75% at end-June 2012). In addition, KBC announced its plan to issue its first covered bonds by the end of 2012, as the Belgian Parliament recently approved their issuances.

The Group’s regulatory capital ratios are strong, if current government capital of EUR 6.5 billion is included. KBC’s aim is to repay the principal amount of EUR 4.67 billion and penalties by the end of 2013, which adds pressure on KBC to deleverage in the absence of improved results. Currently, capital levels have been strengthened with a core capital ratio of 11.8% at end-June 2012 relative to 11.4% in 1Q12 and 10.6% at year-end 2011. Capital has benefited from the finalised sale of KBC’s Polish insurance company Warta, with an estimated positive impact of EUR 0.3 billion or 70 bps. At the same time, the Group’s 2Q12 losses had an impact of EUR 0.6 billion on the Group’s regulatory capital. The execution of these divestments in non-core businesses is expected to lead to reduction in risk-weighted assets (RWA) that is estimated at about EUR 5 billion and will offset the negative impact on capital. On a pro-forma basis, KBC reports that its core capital ratio would be 13.4% at end-June 2012 down marginally from 13.6% at end-March 2012. This level includes the effect of divestments for which a sale agreement has been signed (relative to 12.0% at the end of 4Q11). Excluding State capital, KBC’s core Tier 1 ratio would be 7.3% as of June 2012 (vs. 7.7% as of March 2012).

Notes:
All figures are in EUR unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This commentary was disclosed to the issuer and no amendments were made following that disclosure.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Roger Lister
Approver: William Schwartz
Initial Rating Date: 3 June 2010
Most Recent Rating Update: 20 April 2012

For additional information on this rating, please refer to the linking document under Related Research.