Operations of NLB Group in 2012

Introduction

Instability on the international financial markets, the Slovenian political crisis, deteriorating credit ratings and the continuing economic crisis characterized 2012, and thus had a negative effect on the operations of NLB Group, which generated a loss of EUR 273.5 million, while the loss generated by NLB amounted to EUR 304.9 million. Contributing most to the aforementioned losses was the deteriorating economic situation, accompanied by growth in non-performing loans, which required a high level of impairments. Results before impairments and provisions were positive and were actually better than the previous year, both at NLB and at the Group level.

The activities of NLB Group in 2012 were focused on the implementation of measures to achieve strategic objectives, with an emphasis on divestment, improving cost efficiency and portfolio management. The majority of measures are being implemented according to plans. The results are already tangible, primarily in improving cost efficiency and reducing riskadjusted assets, while the divestment process is of a long-term nature. NLB Penzija was liquidated and LHB Immobilien sold in 2012, while LHB Internationale Handelsbank returned its banking license and was re-registered as a financial company. Further planned sales of nonstrategic investments were postponed to the coming years primarily owing to the unfavorable conditions on the market.

NLB did not encounter any difficulties in securing funding for operations in 2012. It had more than EUR 3 billion in available liquidity reserves. The Bank raised a long-term loan from the ECB in the amount of EUR 1 billion at the beginning of the year. The total scope of refinancing was reduced through the repayment of governmentguaranteed bonds and the early repurchase of subordinated instruments.

The capital position of NLB remains a critical point in the Bank’s operations. The deteriorating capital position is driven by unsatisfactory operating results and the more stringent regulatory requirements imposed by European and Slovenian supervisory bodies. At the request of the EBA, NLB was forced to raise its core tier 1 to 9.0% by the end of June 2012.

The Bank thus carried out several activities in 2012 aimed at increasing capital and reducing capital requirements. A capital increase in the amount of EUR 61.0 million and the issue of a convertible capital instrument (e.g. a subordinated loan that is converted to capital in the event the Group’s capital adequacy deteriorates) in the amount of EUR 320.0 million, both carried out in June 2012, resulted in a direct increase in capital. NLB generated a net gain of EUR 153.0 million through the early redemption of existing capital instruments in June and July in the total amount of EUR 426.4 million, which improved the quality of the capital structure (e.g. core tier 1 and tier 1). The active approach to reducing risk-weighted assets at NLB Group level resulted in a decrease in capital requirements of EUR 196.3 million in 2012.

A change in Slovenian capital legislation entered into force at the end of 2012 and affected the calculation of capital adequacy ratios at the Bank level, but not at the level of the Group. The Bank of Slovenia exercised its discretionary right in the scope of European capital legislation and permitted the parent banks of bank groups to exclude equity investments in subsidiaries that are subject to banking supervision at the consolidated level from the calculation of available capital at the individual level. Due to the aforementioned change, NLB’s regulatory capital grew by EUR 433.1 million and capital requirements for credit risk by EUR 86.6 million, resulting in an improvement in the Bank’s overall capital adequacy ratio by 3.6 percentage points.

The ratings agencies Fitch and Moody’s downgraded NLB in 2012. The reasons given were a deterioration in the credit portfolio and the resulting increase in the number of nonperforming loans, the Bank’s weak capital position, the deteriorating operating environment and the absence of a clear strategy from the government regarding the strengthening of the Bank’s solvency.

State aid programme, initiated by the European Commission

Due to two capital increases received from the Slovene state in 2011 and 2012, the European Commission (“EC”) launched the process of determining the eligibility of this received state aid. For each of the two transactions, the EC issued a temporary decree which in accordance with EU rules on state aid requires the Bank to submit a restructuring plan and imposes various restrictions on the Bank, especially concerning the payment of dividends and returns on capital instruments, commercial strategies and business expansion activities.

The restructuring plan includes measures to be taken by the Bank, which should provide a longterm sustainable and profitable business model of the Bank that will not need state aid for its normal operations ("viability"). The plan also outline the measures that the Bank proposes to take to share the burden of the costs of restructuring and the measures with which the Bank will limit distortions of competition that occurred due to the receipt of the state aid.

The first restructuring plan was submitted to the European Commission in September 2011. On the basis of the second EC decree relating to state aid received by the Bank in 2012, a new restructuring plan, prepared by the management of the Bank and approved by its Supervisory Board, was formally submitted, in January 2013, by the Slovene Ministry of Finance to the EC. The restructuring plan considers the future capital needs of the Bank and Group and includes actions to improve capital adequacy by receiving additional capital or by taking actions in accordance with Slovene Act on the bad bank (Act on actions of the Republic of Slovenia for improving banks’ stability). With the issue of the second temporary decree, the EC launched an official investigation, which will determine the compliance of the state aid with the rules of European law. The process will be completed with the approval of the restructuring plan and the signing of the catalogue of commitments and obligations that the Bank will need to take into account during the restructuring.

Financial review of operations

NLB Group recorded a loss of EUR 273.5 million in 2012, while the loss recorded by NLB amounted to EUR 304.9 million. Comprehensive income, which includes the effects of revaluation recognized in equity, was negative in the amount of EUR 233.3 million at the Group level and negative in the amount of EUR 269.1 million at NLB.

Income statement

Net interest income, which accounts for the highest proportion of NLB Group’s revenue, amounted to EUR 342.5 million in 2012, down EUR 74.8 million or 17.9% on the previous year. The main factors in lower revenues were a contraction in the operations of strategic companies and at companies in the divestment process, and the cutting of reference interest rates. Interest expenses were down on the other hand due to a change in the structure of refinancing and the lowering of the EURIBOR, but to a lesser extent than the decline in revenues.

Both deposit and lending rates were cut in 2012. However, the sharper decrease in the latter had a negative impact on the interest margin, which stood at 2.3% at NLB Group level, a decrease of 0.2 percentage points on the previous year. NLB’s interest margin was likewise down 0.2 percentage points to stand at 1.8%. Banks on the markets of the former Yugoslavia achieved higher margins (of between 3.0% and 4.6%). However, the pressure to drive down the margins on the aforementioned markets is very intense. Companies in the divestment process are contracting their operations and for the most part are not concluding new transactions. The interest income of the aforementioned companies thus no longer covers their costs of financing and results in negative net interest income.

NLB Group’s net non-interest income amounted to EUR 331.8 million in 2012, up EUR 113.6 million or 52.1% on the previous year, primarily as the result of the positive net income generated from financial transactions in which positive one-off effects were realized from early repurchases of subordinated instruments.

Net fees and commissions amounted to EUR 146.1 million in 2012, down EUR 7.3 million on the previous year. The decline in net fees and commissions was the result of fewer transactions and lower turnover, both due to the economic crisis. The most important source of net fees and commissions is net income from payment transactions, which totaled EUR 55.2 million in 2012, down EUR 4.3 million on the previous year. A drop in income from guarantees was also recorded, while income from basic accounts, and from payment card and ATM operations was up. The banks on the markets of the former Yugoslavia pay a deposit guarantee fee through a system of reciprocal deposit schemes. Fees totaling EUR 7.4 million were paid for that purpose.

NLB Group received EUR 4.9 million in dividends in 2012.

Income from financial transactions totaled EUR 165.2 million in 2012, up EUR 131.3 million on the previous year. NLB recorded before tax gains in the amounts of EUR 179.9 million and after tax gains EUR 153.0 million in June and July via the early redemption of subordinated instruments, and a gain in the amount of EUR 9.9 million from the termination of hedging deposits which were released early.

Income from securities trading has been quite volatile in recent years owing to the uncertainty on the capital markets. However, the portfolio of securities held for trading accounts for merely 1% of total assets. NLB Group's exposure to risk from such transactions is thus relatively low. The securities portfolio of the banking book primarily comprises securities held as secondary liquidity reserves. The last Greek bonds were sold in 2012, resulting in a loss of EUR 1.1 million. Exposure to the so-called PIIGS countries was just EUR 20.4 million at the end of 2012.

Other net income amounted to EUR 15.5 million, a decrease of EUR 9.8 million relative to the previous year, as the result of certain extraordinary events such as tax on the purchase of a building by NLB Tutunska banka from NLB Lizing, Skopje (in the negative amount of EUR 4.3 million) and a loss on the sale of LHB Immobilien (in the amount of EUR 1.2 million), while other extraordinary income was recorded in 2011 from the sale of NLB Banka Sofia (EUR 3.9 million). The majority of steady income in this category is accounted for by the sale of IT services, the provision of cash operation services for other banks and rental income.

The rationalization of operations and cost control were two priority tasks again in 2012. Operating costs including amortization and depreciation amounted to EUR 368.2 million at NLB Group, down 3% on the previous year. The costs of labor and material and advertising and representation costs recorded the sharpest declines. Amortization and depreciation costs are also being reduced gradually through the optimization of investments.

The cost-to-income ratio (CIR) improved significantly to stand at 54.6% for NLB Group and 41.3% for NLB, primarily as the result of extraordinary income.

The deepening crisis in the real sector was reflected in the continuing deterioration in the quality of the credit portfolio. The balance of non-performing loans (NPL) has increased despite an overall decline in the credit portfolio. The balance of NPLs stood at EUR 3.7 billion at the end of 2012, an increase of EUR 0.7 billion on the end of the previous year, while the share of NPLs was up 6.9 percentage points to stand at 28.2%.

Owing to the high growth in NPLs, NLB Group created additional loan impairments and provisions of EUR 510.6 million in 2012, a significant increase on the already high impairments created the previous year. The majority of impairments and provisions were created for customers from the sectors of financial holdings, trade, construction, manufacturing, services and finance. The coverage of non-performing loans by provisions (i.e. the coverage ratio) was therefore up 0.2 percentage points in 2012 to stand at 59.3%, while the coverage ratio for the entire portfolio was up 3.2 percentage points to stand at 13.9%.

In addition to impairments and provisions for credit risk, the investments in securities were also impaired in the amount of EUR 30.5 million in 2012 due to declining market values. The majority of the aforementioned impairments relate to securities received as collateral.

Available-for-sale securities were revalued through equity in the positive amount of EUR 45.7 million, and consisted of debt securities in the amount of EUR 29.6 million (Slovenian government bonds accounting for the majority) and equity securities in the amount of EUR 16.1 million, as disclosed in comprehensive income for the financial year.

The negative effects of the operations of subsidiaries are increasingly reflected in the operating results of the parent bank. In 2012, NLB impaired investments in subsidiaries in the total amount of EUR 200.7 million, which represents more than two thirds of the loss generated by the Bank.

The contribution of associates and joint ventures was negative in 2012 owing to the loss generated by Banka Celje and Adria Bank.

Statement of financial position

The scope of operations in non-strategic activities (which are in the process of divestment) is declining in line with strategic objectives, while the scope of operations in NLB Group’s strategic activities is also declining in line with the objective of reducing risk-adjusted items. NLB Group’s total assets EUR 14,334.7 million at the end of 2012, down 12.8% on the end of the previous year. At EUR 11,487.4 million, NLB’s total assets were down 11.5%.

Gross loans to the non-banking sector amounted to EUR 11,458.6 million at the end of 2012, a decrease of EUR 855.2 million on the end of 2011, while net loans to the non-banking sector were down EUR 1,196.1 million owing to higher impairment costs. The stock of loans was down 11.2% in the corporate sector and down 1.7% in the retail sector, while loans to the government were up EUR 211.1 million or 68.2%.

Deposits by the non-banking sector amounted to EUR 9,121.3 million at the end of 2012, a decrease of EUR 1,061.4 million on the previous year. Deposits were down in all segments, particularly in the government sector.

The coverage of loans to the non-banking sector by deposits by the non-banking sector (LTD ratio) stood at 104.7% at the end of 2012 at NLB Group, a decrease of 0.8 percentage points on the previous year. A significant decline in loans to the non-banking sector contributed to the improvement in the aforementioned indicator.

The scope of refinancing was down in 2012. Early redemption of subordinated instruments in the total amount of EUR 426.4 million were carried out in June and at the beginning of July. One of them was replaced by new senior debt in the amount of EUR 136.8 million. Two NLB bonds in the total amount of EUR 109.0 million matured in the second quarter. A government-guaranteed bond was fully repaid in July. Therefore, a longterm loan was raised at the ECB at the beginning of the year, while funding was also secured by reducing secondary liquidity reserves.

Capital and capital adequacy

NLB Group’s regulatory capital stood at EUR 1,168.2 million at the end of 2012, down EUR 331.8 million on the end of the previous year. Capital requirements declined to a lesser extent than capital resulting in a deterioration in the overall capital adequacy ratio, which stood at 10.6% at the end of the year. The quality of the regulatory capital structure improved, as seen in the higher tier 1 and core tier 1, both of which stood at 8.8%.

The Bank mitigated the decline in overall capital adequacy, which was mainly the result of generated losses, through a number of measures aimed at increasing the scope and quality of regulatory capital and at reducing capital requirements. The issue of a convertible capital instrument in the amount of EUR 320.0 million, a capital increase in the amount of EUR 61.0 million (both in June) and a reduction in capital requirements for credit risk of EUR 185.1 million had the greatest positive effect on the overall capital adequacy ratio. The early redemption of equity instruments of lesser quality in June and at the beginning of July resulted in a decrease in total regulatory capital and had a negative effect on the overall capital adequacy ratio, while profits generated led to an increase in book capital, as the highest quality element of regulatory capital, which in turn resulted in an improvement in the tier 1 and core tier 1.

NLB’s capital adequacy ratios on an individual basis improved significantly at the end of 2012 due to a change in the prescribed method for calculating capital adequacy. Less restrictive requirements in the calculation of capital deduction items deriving from equity investments in subsidiaries resulted in an increase in NLB’s capital of EUR 433.1 million and capital requirements for credit risk by EUR 86.6 million, both facilitated an improvement in the Bank's overall capital adequacy ratio by 3.6 percentage points. Legislative changes had no effect on NLB Group’s capital adequacy.

Portfolio

The scope and quality of banking investments were for the most part conditional on developments in the economic environment in 2012. The continuing economic crisis had an adverse impact on the operations of companies, the Bank’s customers and their demand for loans, which was reflected on the one hand in a deterioration in solvency and thus the quality of the banking loan portfolio, and in a reduction in total investments on the other hand. Representing an additional element of risk for banking operations were the prices of instruments used to secure claims, in particular real estate prices, which were down on almost all of the markets on which NLB Group operates.

The high-risk portion of NLB Group’s portfolio thus contracted by 8.2%, while the stock of loans contracted by 7.6%.

Bank investments make up nearly 92% of the portfolio, the operations of leasing companies 3.5% and the claims of trade-finance companies 4.6%. NLB’s portfolio accounts for 79% of NLB Group’s portfolio, while claims against Slovenian customers account for 65%.

Despite numerous improvements and changes to the investment approval process aimed at ensuring a higher-quality assessment of credit risks, the deteriorating recoverability of claims approved in the past continues to have the most significant impact on investment quality indicators. Non-performing loans, defined as the sum of all claims against D- and E-rated customers, and claims against A-, B- and C-rated customers that are more than 90 days past due, stood at EUR 3,683 million at the end of 2012, representing 28.2% of all loans. The sectors of construction, manufacturing and trade account for the most non-performing loans.

The deteriorating quality of the portfolio is also seen in the credit rating structure of claims, as the proportion of D- and E-rated claims rose from 17.7% to 23.8%, while claims against A- and B-rated customers account for 64.9% of the portfolio.

Liquidity management

The timely provision of liquid funds (i.e. liquidity reserves) to finance maturing liabilities is crucial for successful liquidity risk management. The Bank’s liquidity reserves comprise primary and secondary liquidity reserves that the Bank maintains to cover its liabilities and other unexpected cash outlays. Primary liquidity reserves comprise cash, funds on accounts at the Bank of Slovenia, and sight and short-term deposits at banks. The aforementioned sources represent the Bank’s most liquid funds that it can use immediately to cover its liabilities in the event of exceptional stress situations. Secondary liquidity reserves comprise prime debt securities and ECB-eligible loans that the Bank may pledge as collateral with the central bank with the aim of securing additional liquidity.

The Bank maintained liquidity reserves in the amount of EUR 3,482 million as at December 31, 2012, while NLB Group’s liquidity reserves totaled EUR 4,672 million.

The balance of debt securities in NLB Group’s banking book was EUR 2,363 million as at December 31, 2012, a decrease of EUR 544 million on the end of 2011. Government securities accounted for 87% of the aforementioned amount, followed by government-guaranteed bank bonds at 8% and bank and corporate securities at 5%.

EUR 1,233 million or 52.2% of securities were classified as available-for-sale, while EUR 1,041 million or 44.1% were classified as held-tomaturity. The duration of the portfolio is 2.4 years, taking into account derivatives.

Exposure to the PIIGS countries (Portugal, Ireland, Italy, Spain and Greece) declined by a further EUR 1.5 million in 2012 to stand at EUR 20.4 million (measured in nominal value), and remains immaterial with respect to the Bank’s capital.

Funding

Banks were faced with fewer opportunities to borrow in 2012 due to the difficult conditions on the financial markets and the downgrading of credit ratings. NLB nevertheless raised three bilateral loans in the total amount of EUR 136.8 million for the general needs of its operations.

NLB thus improved its capital structure and capital adequacy ratio and restructured four existing subordinated instruments based on the consent of the Bank of Slovenia and European Commission. The aforementioned restructuring included the repurchase of an innovative instrument at a discount, the repurchase of two hybrid instruments at a discount and the conversion of subordinated debt into senior, unsecured debt at a discount. Repurchases and conversions totaled EUR 426.4 million, from which NLB generated a pre-tax gain of EUR 179.9 million. The Bank also signed an agreement with the Republic of Slovenia on a hybrid loan in the amount of EUR 320.0 million.

In an effort to harmonize NLB Group, all borrowing by Group companies on the international financial markets was centralized at NLB. The focus of the funding of Group companies was on borrowing from domestic and foreign commercial banks. The scope of foreign borrowing was down, while NLB Group companies borrowed a total of EUR 67.4 million from commercial banks.

Similar to previous years, the Bank intends to refinance liabilities from funds secured from banks, financial institutions and multilateral financial institutions in 2013. It will continue to follow the principle of diversifying its sources of funding, with a greater emphasis on refinancing from collected deposits.