Principles

The following description of the risk management system is based on the structure and functional principles of the Cooperative Financial Network’s institutional protection scheme at a primary level, but also takes into account the risk management of the individual institutions as a secondary element. In this context, risk management at the level of the protection scheme is mainly focused on preventing individual institutions from getting into difficulties.

Risk reporting covers all entities in the scope of consolidation for the purposes of commercial law. The scope of consolidation for the consolidated financial statements therefore goes beyond the companies consolidated for regulatory purposes and is not limited to the members of the protection scheme.

The BVR protection scheme and BVR Institutssicherung GmbH ensure the stability of the entire Cooperative Financial Network and confidence in the creditworthiness of all its members. Both schemes together, and each in its respective functions and area of responsibility, form the backbone of risk management in the Cooperative Financial Network.

Institutional protection scheme of the Cooperative Financial Network

BVR protection scheme (BVR-SE)

BVR-SE is Germany’s and the world’s oldest deposit guarantee fund for banks and is financed entirely without government support. Right from its inception, this system has always ensured that all banks covered by the scheme have been able to meet their financial obligations – especially toward retail customers holding deposits. BVR-SE is regulated and monitored by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) [German Federal Financial Supervisory Authority].

Since the German Deposit Guarantee Act (EinSiG) came into effect on July 3, 2015, when it became necessary to establish a legally recognized deposit guarantee scheme, BVR-SE has been continued as an additional voluntary bank-protection scheme in accordance with section 2 (2) and section 61 EinSiG.

The main responsibilities of BVR-SE are to ensure stability by averting imminent financial difficulties or eliminating any such existing problems at the affiliated institutions and to prevent any negative impact on confidence in the Cooperative Financial Network. So that it can provide the necessary support in securing these aims, BVR-SE has access to a guarantee fund that is funded by contributions from the member banks. If necessary, the institutions will also support each other with additional funding (guarantee obligations).

In 2019, BVR-SE met, without qualification, all its responsibilities as a bank-protection scheme in accordance with the articles of association, as set out in the annual financial statements of BVR-SE. A total of 851 institutions of the Cooperative Financial Network belonged to BVR-SE as at December 31, 2019 (December 31, 2018: 885 members). The decrease stemmed solely from mergers within the Cooperative Financial Network.

BVR Institutssicherung GmbH (BVR-ISG)

BVR-ISG is an officially recognized deposit guarantee scheme and, since July 1, 2015, has been operating an institutional protection scheme within the meaning of article 113 (7) of Regulation (EU) No. 575/2013 for CRR credit institutions that has been approved by the regulator. By operating the institutional protection scheme, BVR-ISG satisfies its responsibility under its articles of association to avert or eliminate imminent or existing financial difficulties in its member institutions. To this end, BVR-ISG will initiate any preventive or restructuring action, as required. Where, in accordance with section 10 EinSiG, BaFin identifies a compensation event in relation to a CRR credit institution that is a member of the BVR-ISG protection scheme, BVR-ISG will compensate the customers of the credit institution concerned in accordance with sections 5 to 16 EinSiG. BVR-ISG thus fulfills the statutory requirements regarding deposit protection for customers.

Together, BVR-ISG and BVR-SE form the Cooperative Financial Network’s dual protection scheme. The members of the BVR-ISG protection scheme are those CRR credit institutions that also belong to the BVR and are affiliated to BVR-SE. As at December 31, 2019, the membership comprised 849 CRR credit institutions (December 31, 2018: 883), which is all of the banks in the Cooperative Financial Network that are authorized in Germany by BaFin.

Under section 50 (1) EinSiG, BVR-ISG is subject to supervision by BaFin and to monitoring by the Bundesrechnungshof [German Federal Court of Audit] with regard to its responsibilities to compensate depositors in accordance with sections 5 to 16 EinSiG and with regard to funding and target funding levels in accordance with sections 17 to 19 EinSiG.

To the extent possible under EinSiG, BVR-ISG’s organizational and decision-making structures match the organizational and decision-making structures of BVR-SE. Dual employment contracts and a service agreement are in place so that BVR-ISG’s day-to-day business operations can be carried out by the BVR employees who perform the corresponding functions for BVR-SE. BVR-ISG has also engaged a third-party service provider to carry out the processing of potential compensation procedures, although such procedures have as yet never been required, nor are any currently identifiable.

The focus of the activities of BVR-ISG in 2019 was on fulfilling its responsibilities as defined by law, the articles of association, and regulatory requirements. The activities centered on the risk-based collection of contributions, which is compliant with the relevant guidance of the European Banking Authority (EBA), the management of funds, extensive operational stress tests, and preparations for the IPS recovery plan in accordance with the Minimum Requirements for the Design of Recovery Plans (MaSan). BVR-ISG can look back on a highly successful year, having not had to take any action to protect depositors or banks or pay any compensation in accordance with section 145 of the German Bank Recovery and Resolution Act (SAG) at any time in 2019.

Risk identification and analysis

Basic structures
The Cooperative Financial Network is a decentralized organization made up of legally independent institutions that are linked – through BVR-SE – by their liability. This decentralized element is in contrast with banking groups that have a parent company at the top of a hierarchical structure. Consequently, the power to make business decisions lies with each individual institution and its independent Board of Managing Directors and Supervisory Board. This decentralized structure determines the focus of risk management for BVR-SE. The focus is above all on overall analysis of the financial risk carriers – i.e. the institutions – rather than on isolated analysis of individual risk types and their scope. This fundamental methodological approach ensures that, in establishing that each individual institution’s financial position and risk position are appropriate and its financial performance is adequate, the entire system – i.e. the entire Cooperative Financial Network – as a unit can be considered to be on a sound economic footing.

BVR-SE has appropriate systems for identifying and classifying risks and for monitoring the risks of all its members and of the institutional protection scheme as a whole. Risks are rated on the basis of BVR-SE’s classification system, which was implemented in 2003. The aim of this rating process, which is based on the annual financial statements, is to obtain an all-round, transparent view of the financial position, financial performance, and risk position of all members. Rating a bank in accordance with the classification system provides the basis for determining the risk-adjusted guarantee fund contributions of BVR-SE and is also the starting point for preventive management.

The results of the classification are supplemented by further analysis and data, in particular evaluations of the data collected as part of an annual comparative analysis. This is a data pool that the BVR compiles from data collected from its member institutions and is predominantly based on information from the institutions’ accounting and reporting systems. The data from the annual comparative analysis forms the basis for analyses that use key risk indicators to identify and examine particular abnormalities. In addition, BVR-SE prepares special analyses on specific issues and specific risks, such as determining the impact of sustained low interest rates.

In accordance with its risk-oriented mode of operation, BVR-SE performs individual bank analyses on institutions of major financial significance to the protection scheme as a whole. In doing so, BVR-SE is applying the concept used to analyze large banks. It thus takes into account the risks resulting from the size category of the affiliated institutions.

To assess BVR-SE’s risk-bearing capacity, probabilities of default are determined on the basis of various stress scenarios and Monte Carlo simulations are used to calculate the possible restructuring amounts. This involves carrying out scenario-specific classifications on the basis of different assumptions (e.g. interest-rate changes, declining credit ratings in the customer lending business).

Classification process and contributions to the BVR protection scheme
The classification system uses eight key figures relating to financial position, financial performance, and risk position to assign the banks to one of the nine credit rating categories, which range from A++ to D. The classification system is based on quantitative key figures, most of the data for which is taken from the banks’ audited annual financial statements and audit reports. BVR-SE receives this data electronically from the regional auditing association responsible for the individual bank.

All institutions covered by BVR-SE are included in the classification system. Only a small number of institutions are not included, notably those that are rated separately by an external rating company, e.g. DZ BANK AG and its subsidiaries as well as Münchener Hypothekenbank eG.

The classification process in 2019 was based on an analysis of data from the 2018 financial statements. The evaluation of this data revealed that the profit and loss distribution deteriorated on average, but remains at a high level overall. Only a small portion of this deterioration was attributable to the core business of the cooperative banks. For the most part, it was caused by losses on securities in the wake of disruption in the market at the end of 2018. Over the course of the reporting year, significant amounts of impairment losses were reversed and the results of the classification are therefore expected to improve noticeably for the 2019 financial year. The decline in net interest income was more than offset by growth in net fee and commission income. The cost/income ratio rose due to higher general and administrative expenses and a slight fall in operating profit. Loss allowances for loans and advances remained at a historically low level in the 2018 financial year. The proportion of unsecured lending classed as loans with a high probability of default or as non-performing loans increased year on year but still remained well below the total volume of 2016.

Risk management and monitoring

Preventive management
The aim of preventive management is to identify and counteract adverse economic trends at an early stage, thereby helping to prevent the need for supporting measures. Data and other information from the banks that might be affected is analyzed and, following additional discussions with the management of these banks, the necessary measures aimed at stabilizing and improving their business performance are agreed.

The results of the classification process provide an important basis for BVR-SE’s systematic preventive management. A bank is brought into the scope of this preventive management approach no later than the point at which it is classified as B– or lower on the basis of its annual financial statements. In addition, other key figures and comprehensive data (e.g. from the banks’ reporting systems and the stress tests that the supervisory authority has started to conduct regularly even for domestic, not systemically important banks) have increasingly been used over the past few years so that any anomalies at institutions can be identified at an early stage. In 2019, this data included multi-year planning information from the banks’ reporting systems, all of which was made available to BVR-SE.

Before the prevention phase, the monitoring of conspicuous institutions is playing an ever more significant role in the early analysis of institutions. In 2019, the monitoring program once again also reached out to institutions that were not showing any particular indications of risk but that could potentially represent a major risk simply because of the size of their balance sheet. This underpins the long-term trend of shifting the focus of BVR-SE’s work away from restructuring and toward end-to-end preventive management that also includes monitoring.

Restructuring management
As before, the work of BVR-SE in restructuring member institutions is aimed at ensuring that these institutions’ annual financial statements are able to receive an unqualified auditors’ opinion, which it does by providing restructuring assistance. The next stage is to contractually agree the measures required in order to ensure that the bank’s business regains its future viability while accommodating the interests of all members of the Cooperative Financial Network.

The ‘Manual for future-proof bank management – guidelines for reorganizing and restructuring cooperative banks’, which was revised in 2017, remains the basis for providing restructuring assistance and carrying out restructuring measures. The principles documented in the manual provide affected banks with guidance on re-establishing competitive structures, e.g. through recovery, and describe concepts for restoring their fundamental profitability. The aim is for the banks to complete this restructuring phase within no more than five years. BVR-SE’s manual is also specifically aimed at banks undergoing preventive measures and any institutions that have themselves identified the need for reorganization. The manual also includes a dedicated section setting out detailed procedures for restructuring measures that need to be carried out in close consultation with the bank undergoing restructuring and the relevant statutory cooperative auditors’ association. This section of the manual addresses different potential target institutions separately and can be applied specifically to each individual case.

BVR-SE largely continued to perform well in the year under review in terms of its restructuring activities. In 2019, supporting measures needed to be provided to two member banks for the first time, but the cost to the institutional protection scheme (a total figure in the single-digit millions of euros) was negligible relative to the scheme’s net assets. Further very minor costs were once again incurred for legacy cases where risks already covered had become acute or loss allowances were recognized in BVR-SE’s annual financial statements. These legacy cases are being progressively reduced. As BVR-SE also focused on dealing with and finalizing legacy cases in 2019, the level of restructuring activity fell to an almost immaterial level in the reporting year. The total restructuring amounts in need of protection were significantly lower than expected and there was only a small volume of repayments under debtor warrant obligations and other guarantee release obligations.

The overall performance meant that the capital base of the dual cooperative institutional protection scheme (comprising BVR-SE and BVR-ISG) was strengthened once again in 2019 and, as planned, the statutory guarantee fund resources at its disposal could be expanded yet again.

Outlook for the BVR protection scheme and BVR Institutssicherung GmbH

The dual institutional protection scheme will be no exception in that the economic fallout from the global coronavirus pandemic in 2020 will be the first and foremost challenge for it to deal with, although the extent of the challenge remains unknown. The possibility that the cooperative banks’ envisaged results for the 2020 financial year and beyond might be severely affected by the further course of the pandemic cannot be ruled out. Against this backdrop, the BVR protection scheme anticipates an increase in support measures over the coming years.

In 2020, BVR-ISG continues to face the task of implementing regulatory requirements, such as preparing recovery plans within the meaning of sections 12 to 20 SAG. The Regulation on the Minimum Requirements for the Design of Recovery Plans for Institutions (MaSanV) was published at the end of March 2020, but in light of the coronavirus pandemic, no implementation measures of relevance to either BVR-ISG as an institutional protection scheme or the member banks have been adopted yet (expected for the autumn of 2020 at the earliest). It is also likely that new disclosure requirements will arise as a result of indirect and sectoral supervision by the ECB, in particular broader and stricter requirements at the level of the Cooperative Financial Network. BVR-SE expects yet more issues to emerge in this regard, involving international institutions such as the European Single Resolution Board (SRB), the EBA, and the European Commission. Such issues could affect BVR-SE and/or BVR-ISG. In addition, the EBA is due to carry out further activities in connection with the regular review of the EU Deposit Guarantee Schemes Directive (DGSD), which was scheduled for 2019 back in 2014. BVR-ISG will be supporting these activities by participating in a number of the EBA task force’s working groups. The final report is scheduled to be completed by mid-2020.

Regulatory capital management

The consolidated financial statements of the Cooperative Financial Network provide a comprehensive overview of the main capital ratios, particularly the consolidated regulatory capital ratios. These capital ratios are calculated in accordance with the provisions of the CRR using the extended aggregated calculation pursuant to article 49 (3) CRR in conjunction with article 113 (7) CRR. Information concerning the regulatory capital ratios relates to the reporting date of December 31, 2019 and does not include the retention of the profits reported in the 2019 annual financial statements. Profit is retained after the individual institution’s relevant committees have given their approval. This retention of profits will further strengthen the capital base in 2020.

The Tier 1 capital ratio improved to 13.7 percent (December 31, 2018: 13.6 percent). If the reserves pursuant to section 340f HGB are classified as Tier 1 capital, the Tier 1 capital ratio is 15.5 percent (December 31, 2018: 15.6 percent). The Cooperative Financial Network’s regulatory total capital ratio was 15.6 percent as at December 31, 2019 (December 31, 2018: 15.8 percent). Overall, regulatory own funds increased by €5.3 billion to €107.0 billion. The rise in own funds was largely attributable to the retention of profits from 2018 by the cooperative banks, which was reflected in the ratios as at December 31, 2019. The Cooperative Financial Network’s capital is predominantly held by the cooperative banks.

The total risk exposure as at December 31, 2019 amounted to €685.4 billion (December 31, 2018: €642.4 billion). This 6.7 percent increase was driven by growth in the customer lending business, in both the retail and the corporate banking segments.

BVR-SE analyzes the regulatory capital ratios of each member bank on an ongoing basis. The institutions themselves are responsible for fulfilling the regulatory requirements at all times, including in respect of bank-specific SREP surcharges (e.g. for interest-rate risk, other material risks, and/or stress test results). As shown by the chart 'Distribution of total capital ratios in the Cooperative Financial Network', the capital adequacy of the individual institutions in the Cooperative Financial Network was at a healthy level as at the reporting date of December 31, 2019. This had also been the case as at December 31, 2018.

The Cooperative Financial Network has healthy capital adequacy thanks to equity of €116.0 billion (December 31, 2018: €107.7 billion). It has continually boosted its level of capital in recent years by retaining profit. This trend substantiates the Cooperative Financial Network’s sustainable business model with its broad diversification of sources of risk and income.

The leverage ratio, which is calculated for the Cooperative Financial Network on a pro forma basis, came to 7.0 percent as at December 31, 2019 (December 31, 2018: 6.9 percent). This is further proof of the above-average capital adequacy of the Cooperative Financial Network. The ratio is calculated for the Cooperative Financial Network by applying the requirements (adjusted appropriately) of article 429 CRR. This was based on Tier 1 capital as determined in the extended aggregated calculation in accordance with article 49 (3) CRR, which is adjusted for all internal Tier 1 capital positions within the joint liability scheme of the Cooperative Financial Network. The risk exposures were determined by aggregating the individual leverage ratio submissions of all the member banks and adjusting them for material internal exposures within the joint liability scheme. This approach factors in the zero weighting given to internal exposures within the network, which will be implemented for the member institutions when CRR II is introduced. If the reserves pursuant to section 340f HGB are classified as Tier 1 capital and relevant CRR I requirements are fully applied, the Tier 1 capital ratio was unchanged year on year at 7.8 percent. The leverage ratio total exposure increased by 6.0 percent year on year, rising to €1,345.6 billion.

Economic capital management

Risk capital management is a core task at each individual institution. Pursuant to the Minimum Requirements for Risk Management (MaRisk), it must be structured according to the complexity, scope of business activities, and size of the bank. The banks receive procedural support through the VR Control processes and VR Control software.

Risk capital management is influenced by two factors: firstly the business necessity of optimally allocating risk capital to various risk categories while taking account of risk/reward considerations and, secondly, the requirements of the Internal Capital Adequacy Assessment Process (ICAAP). The BVR drew up the necessary integrated concept in the VR Control update project and made it available to the banks. parcIT has been handling the further development of the approach since April 2019 and made updated risk-bearing capacity guidelines available in the autumn of 2019.

At a business management level, the interest-rate and credit risk categories – usually the main risk categories for the cooperative banks – are included in the optimization calculation. According to the basic concept of capital market theory, where there are given risk/return figures in each class and each correlation, combinations can be found that ensure an optimum ratio in the overall portfolio at overall bank level.

Alongside these business considerations, the banking regulator has supplemented risk measurement in Pillar I with its own Supervisory Review and Evaluation Process (SREP) and worked out a system of bank-specific surcharges for interest-rate risk and other material risks as well as a stress scenario surcharge. The surcharges for the individual cooperative banks were once again met in 2019 and the surcharges for other material risks fell sharply compared with 2018.

The proportionality of the individual institutions is taken into account when managing risk-bearing capacity in connection with risk capital management. The German banking regulator has comprehensively redrafted the 2011 prudential paper on the supervisory assessment of bank-internal capital adequacy concepts and, with the aim of harmonization, adapted it to the principle of significant institutions (SIs). The new concept for risk-bearing capacity consists of both a normative perspective (capital planning for a three-year period) and an economic perspective that is based on complete risk modelling from a value-based perspective.

This new concept means a change of method for the institutions, because more than 99 percent of them previously applied a going-concern approach using HGB results. To help them with this change, the BVR has – as part of its remit to act as a catalyst and provide technical guidance – put in place various support services designed to equip the cooperative banks to tackle the challenges that they will face going forward. Cooperative banks, auditing associations, the computing center, and DZ BANK were involved in drawing up the concept. Alongside the project, an impact analysis was conducted at a number of banks. It confirmed their resilience, including under the new approach.

The new concept provides the basis for the necessary IT-based implementation support and should enable the banks to carry out the required calculations using their existing IT tools. Full implementation of the new guidelines will take some time and, after the banks’ experts have studied them in detail, there will be an initial trial phase before the banks switch to the new calculation. A solution that largely integrates the new risk-bearing capacity concept into the VR-Control software is scheduled to be made available in 2021. The banking regulator specifically stated in an annex to the guidelines that there is a time-limited option to continue with the old going concern model during transition to the new concept. A specific date on which this annex will cease to apply has not been announced yet.

Credit ratings of the Cooperative Financial Network

The credit ratings of the Cooperative Financial Network remained unchanged at AA- in 2019. However, Standard & Poor’s changed its outlook assessment from ‘stable’ to ‘negative’ in September 2019 and Fitch Ratings did the same in March 2020. The agencies cited the downturn in the macroeconomic environment as the reason for their adjustment. The agencies’ views on the rating drivers, the business model, and the economic strength of the Cooperative Financial Network have not changed. The credit ratings are based on the economic strength of the Cooperative Financial Network. This can be seen from the individual ratings, which are all at an identical level. The rating agencies point to the consistently successful business model focused on retail and corporate banking as the reason for their positive assessment. The funding of the business model is based on customer deposits, so it is structurally secured. Liquidity is ensured at all times by means of an extensive and highly diversified portfolio of marketable securities, combined with the cash pooling that takes place within the Cooperative Financial Network. Capital adequacy is also judged to be above average in terms of quantity and quality. The rating agencies recognize the ability and note the propensity of the Cooperative Financial Network to build up capital from its own resources by retaining profits. The granular credit structure and high proportion of mortgages in the retail business are the hallmarks of the overall high level of quality in the customer lending business. BVR-SE is seen by the rating agencies as an important connecting link and a crucial element of the risk management system of the Cooperative Financial Network.

Credit risk

Credit risk is the risk of losses that may arise as a result of the default or a deterioration in the creditworthiness of a borrower, issuer, counterparty, or equity investment. As at December 31, 2019, the credit risk-weighted assets of the Cooperative Financial Network amounted to €618.0 billion (December 31, 2018: €575.5 billion) and accounted for 90.2 percent (December 31, 2018: 89.6 percent) of the total risk-weighted assets. This means that credit risk is the most significant risk category for the cooperative banks.

To assess the creditworthiness of individual borrowers in the customer business, the banks use segment-specific rating systems that are validated centrally on an ongoing basis in accordance with high market standards. These rating systems are also subject to continual further development in order to ensure that all relevant segments of the customer lending business are covered. The vast majority of the banks, particularly when analyzing risk-bearing capacity, use portfolio models to measure risk at portfolio level. These models are also constantly validated at both overall model level and parameter level.

The Cooperative Financial Network’s strategy focuses on the profit-oriented assumption of risk, while taking its level of equity into consideration and pursuing a risk-conscious lending policy. The cooperative banks are conservative in their lending decisions. Their knowledge of customers plays a central role, as does the capacity of customers to meet their obligations. Overall, the Cooperative Financial Network’s customer lending business has a granular credit structure and a high proportion of mortgages. The granularity and extensive regional diversification of the Cooperative Financial Network’s business activities limit the formation of risk clusters.

The Cooperative Financial Network registered significant growth in its lending business in 2019. Loans and advances to customers increased by 6.2 percent year on year. Once again, long-term home finance was a key growth driver. Home finance lending by the cooperative banks benefited from the favorable economic conditions. The combination of low interest rates, a healthy level of employment, and rising household incomes fueled strong demand for real-estate loans. Residential real-estate prices in Germany continued to go up in 2019, but at a slightly slower rate. On average across all 401 municipal and rural administrative districts, prices for owner-occupied residential properties rose by 5.7 percent (2018: 5.9 percent). The price rises were geographically well distributed in 2019. The upward trend continued in both urban and rural areas, but the gap between the rate at which city and country price levels are increasing has narrowed.

To help the member institutions to monitor the regional markets, the BVR teamed up with vdpResearch GmbH to develop a concept for measuring market volatility in individual postal code areas: BVR real-estate market monitoring. The measurements from BVR real-estate market monitoring provide additional regional information to complement the German Banking Industry Committee’s market volatility concept. This enables the cooperative banks to determine the geographical areas forming their relevant markets and better comply with regulatory requirements.

The growth in corporate banking was predominantly driven by lending to service sector companies, the construction sector, and companies from the energy and mining industries. Because of their regional roots, the local cooperative banks have also established a strong foothold in the renewable energies market and provide financial support to companies in relation to projects for increased energy efficiency and for power generation from renewable sources.

Loss allowances rose to €0.8 billion in the reporting year (2018: €0.2 billion). This was mainly due to the increase in lending business and a greater requirement for loss allowances on exposures in ship and offshore financing. Loss allowances remained low at 0.1 percent (December 31, 2018: 0.02 percent) of the volume of loans and advances to customers and banks (total volume: €867.0 billion). As at December 31, 2019, the Cooperative Financial Network’s NPL ratio (non-performing loans as a proportion of the total lending volume) stood at 1.4 percent (December 31, 2018: 1.7 percent). This encouraging decrease in the NPL ratio was attributable to contraction of the volume of NPLs and a rise in the total lending volume. In summary, the cooperative banks operate a healthy lending business overall.

Market risk

Market risk is the risk of losses that could arise from adverse changes in market prices or in factors that influence prices. Market risks are generally grouped into the following categories: equity risk, interest-rate risk, and currency/commodity risk. As at December 31, 2019, the market risk-weighted assets of the Cooperative Financial Network amounted to €12.7 billion (December 31, 2018: €12.9 billion) – equivalent to a proportion of 1.9 percent of the total risk-weighted assets (December 31, 2018: 2.0 percent).

Along with credit risk, interest-rate risk – a category of market risk – plays an important role for most of the cooperative banks. The cooperative banks regularly measure and limit this risk with regard to their risk-bearing capacity. A distinction is made between interest-margin risk and valuation risk. Interest-margin risk is the risk of net interest income falling short of the expected or budgeted figure. Valuation risk is influenced by unexpected price volatility during the holding period. For the purposes of determining and managing periodic interest-rate risks, parcIT regularly provides non-portfolio-specific interest-rate scenarios (VR interest-rate scenarios), which contain not only upward and downward shifts but also rotations of the yield curve. The moderate interest-rate movements in 2019 were adequately covered by the VR interest-rate scenarios used to manage interest-rate risk in the reporting year. In addition, the regulatory interest-rate scenarios specified in the BaFin Circular 06/2019 (BA) for the currencies CHF, DKK, EUR, GBP, JPY, and USD were provided centrally by parcIT.

Interest-rate risk has a significant influence on the banks’ financial performance. Due to the persistently low interest rates, the Cooperative Financial Network’s net interest income in 2019 reduced by 1.0 percent compared with the previous year. As in prior years, the largest proportion of net interest income was generated from the net interest margin contribution in the customer business. Given the persistently low level of interest rates and growing competition for deposits, the banks expect interest margins to be narrower in the future. There is also still the risk that funding costs will rise when interest rates in the financial markets start to climb again. Supervisory authorities are factoring this problem into appropriate regulatory activities. For example, the Basel Committee on Banking Supervision published its new ‘Interest-rate risk in the banking book’ standard in 2016, which came into force in 2018. The EBA published its new ‘Guidelines on the management of interest-rate risk arising from non-trading book activities’ in 2018, which came into force on June 30, 2019. They introduce an early-warning indicator, for which there is a six-month transitional period. One aspect common to both the Basel standard and the EBA guidelines is that, although they continue to provide for the modeling of interest-rate risk in the banking book in Pillar II, they place greater emphasis on the quality and consistency of the management of interest-rate risk in institutions. If the internal management does not satisfy the requirements of supervisors, they can require an institution to use a standard model as described in the new Basel standard. The aforementioned new requirements under EBA guidelines were taken into account in the BaFin Circular 06/2019.

BVR-SE monitors the appropriateness of the member institutions’ level of interest-rate risk, for example by using simulations to calculate net interest income. These simulations show that the local cooperative banks will continue to generate an adequate level of income going forward, not least as a result of the control mechanisms that they have in place.

Liquidity risk

Liquidity risk refers to the risk of the bank becoming unable to meet its payment obligations. In accordance with the cooperative principle of subsidiarity, each cooperative bank is in charge of its own liquidity and risk management. Compliance with the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) – regulatory Pillar 1 key figures – is mandatory in this context. In addition, a range of business management tools are available that enable individual cooperative banks to define and manage a bank-specific internal liquidity adequacy assessment process (ILAAP). The relevant concepts, which were developed in 2018 with the BVR taking a leading role, are being rolled out across the system in several stages.

The degree to which a bank is able to guarantee its ability to meet its payment obligations in the short term is measured using the LCR. Banks are required to maintain a sufficiently high level of liquidity as measured by this key figure. As at December 31, 2019, the median LCR of all cooperative institutions was 174.3 percent (December 31, 2018: 165.7 percent).

For many years, the Cooperative Financial Network has had a reliable liquidity structure that is deemed crisis-resistant. The loan to deposit ratio of the Cooperative Financial Network is 95.9 percent (December 31, 2018: 94.4 percent). The basis for this lies in the diversifying, risk-mitigating effect created by the stable business structure of the banks, which tends to be divided into small units, and, in particular, in the institutions’ traditional method of obtaining funding through customer deposits. Customers therefore recognize and reward the effectiveness of the institutional protection provided by BVR-SE and BVR-ISG, which particularly aim to safeguard deposits.

The liquidity system of the Cooperative Financial Network is characterized by the strong portfolio of deposits from retail and corporate customers. This deposit portfolio has a highly granular structure and is growing steadily. The liquidity is invested by DZ BANK AG. As the central institution, it is responsible for offsetting liquidity peaks across the cooperative banks by pooling excess liquidity from individual institutions and balancing out differences in the liquidity levels of individual cooperative banks. Information about the liquidity situation of the individual banks is shared with DZ BANK on an ongoing basis, ensuring that the central institution is in possession of a complete picture at all times.

Operational risk

Based on the definition used by the banking regulator, operational risk is the risk of losses arising from inadequate or failed internal processes, personnel, or systems, or from external events. As at December 31, 2019, the risk-weighted assets of the Cooperative Financial Network attributable to operational risk amounted to €50.2 billion (December 31, 2018: €50.9 billion) – equivalent to a proportion of 7.3 percent of the total risk-weighted assets (December 31, 2018: 7.9 percent).

The systems and internal processes implemented by the cooperative banks aim to reduce operational risks. A variety of measures are taken to address operational risk, including clear procedural instructions, separation of functions, the use of standardized contract templates that have been reviewed by a legal expert, and the appointment of security, compliance, data protection, and anti-money-laundering officers. In addition, business continuity plans for failure of technical equipment and unexpected staff absences are in place.

Internal control processes ensure that material operational risks are identified, analyzed, and assessed on a regular basis. The institutions can use guidelines to conduct a systematic risk assessment in keeping with market standards. Any loss event is recorded in a database. Based on the outcome of the loss event analysis, internal procedures are adjusted and preventive safeguards implemented as necessary.

Operational risk is measured in consideration of the business model of the individual institution. The dominant methods are quantification by means of a plausible lump sum or based on historical loss event data, sometimes supplemented by value-at-risk (VaR) approaches.

Customer membership is a distinctive feature of the cooperative banks’ business model and one that is ideally suited to conveying the values of the cooperative idea. It offers the cooperative banks the opportunity to distinguish themselves from rival banking groups. The cooperative banks’ distinctive characteristics are reflected in their continued ability to reach a wide range of customers. Strong customer retention results in measurable economic benefits, e.g. income growth for the cooperative banks and the protection of their market share.

Even in the digital age, the business model of the cooperative banks puts people and their wishes and objectives first. In the years ahead, the digitalization initiative launched by the Cooperative Financial Network in the retail and corporate banking businesses will enable it to proactively adapt to the changes in the competitive environment resulting from the digital revolution. The aim is to forge ahead with digitalizing the cooperative banks’ products and services and offer all of the touchpoints that customers want (local branches as well as online and mobile banking).

The implementation of measures derived from the KundenFokus (customer focus) project continued and there has been capital expenditure in connection with the digitalization initiative. This allows the Cooperative Financial Network to take account of the changes in customer behavior and to adjust and strengthen the overall business model accordingly. The focus is on the comprehensive omnichannel presence and thus the implementation of efficient processes at all levels. Nonetheless, personal contact remains a key component of the customer relationship, alongside high-quality advice and the possibility for customers to choose how they would like to communicate with their bank. The Cooperative Financial Network is therefore establishing a variety of different customer touchpoints and giving its members integrated access to all information and services through all the relevant channels – whether in branch or via digital media.

Digitalization, with its increasing influence on members’ behavior, also offers the banks potential to improve their cost structure in the medium term. By marketing new digital payment services, such as contactless payments, paydirekt, and Kwitt, and implementing an online inquiry process for all of the main products, banks are able to address customer needs and attract new customers. This also enables them to target young, tech-savvy customers and members.

Consumer spending is expected to be boosted further by the positive trends in employment and disposable income. This will stabilize demand for banking products and services. Given the current low level of interest rates, the cooperative banks will continue tapping into potential in the real estate business. Should there be a sustained rise in interest rates, opportunities will open up in connection with the sale of interest-bearing financial products.