This management report supplements the annual consolidated financial statements of the Volksbanken Raiffeisenbanken Cooperative Financial Network.

The Volksbanken Raiffeisenbanken Cooperative Financial Network consists of 915 primary banks (2016: 972), the DZ BANK Group, Münchener Hypothekenbank eG (MHB), the BVR protection scheme, and BVR Institutssicherung GmbH as consolidated entities. The consolidated primary banks include Deutsche Apotheker- und Ärztebank eG, the Sparda banks, the PSD banks, and specialized institutions such as BAG Bankaktiengesellschaft.

The primary banks and MHB are the legally independent, equally ranked parent entities of the Cooperative Financial Network, whereas the other entities and corporate groups are consolidated as subsidiaries.

The economic upturn in Germany, which began back in 2013, continued in 2017 and again resulted in above-average economic growth. The latest official figures show that gross domestic product (GDP) adjusted for inflation rose by 2.2 percent year on year, a slightly higher rate than in 2016 (1.9 percent).

During the upturn to date, economic growth has seen relatively little fluctuation from quarter to quarter, and this was again the case in 2017. Global uncertainties, such as the announcement of a hard exit from the EU by the UK, evidently hampered Germany’s economic growth only slightly. A key reason for this is likely to be that the domestic economy was a greater growth factor than foreign trade.

Once again, the main drivers of economic growth were government and consumer spending in 2017. Trends in the labor market were again favorable, wages continued to rise, and consumer price inflation remained moderate, which meant consumer spending increased at a similarly strong rate to the previous year.

Capital expenditure and foreign trade also contributed to the growth of GDP. Exports rose at a faster rate than in 2016. However, as imports also went up significantly, foreign trade did not provide much additional impetus for overall economic growth in absolute terms. Investing activities gained a little momentum. As a result of increasing capacity utilization in industry, there was a sharper rise in spending on capital equipment than before. The pace of growth in construction investment remained high.

Business situation

In a difficult market environment that was predominantly characterized by extremely low interest rates, fierce competition, and demanding regulatory requirements, the Volksbanken Raiffeisenbanken Cooperative Financial Network had yet another successful year in 2017. Profit before taxes amounted to €8,916 million, exceeding the prior-year figure of €8,308 million by €608 million. With its focus on value creation and customers, the regionally oriented business model of the Cooperative Financial Network again proved robust and reliable in these difficult operating conditions.

In 2017, the cooperative banks generated strong and stable growth in their lending business with retail and corporate customers. Overall, lending to retail and corporate customers increased by 5.6 percent, which was 1.1 percentage points above the 2016 growth rate of 4.5 percent. Once again, the main driver of this sustained growth in the lending business was brisk customer demand for personal home loans. The cooperative banks slightly increased their share of the retail customer market once again compared with the previous year. Their share of the corporate customer market was also slightly higher. This was attributable to a buoyant level of lending to the service and construction industries. The cooperative banks are market leaders for lending to agriculture and forestry. The deposit-taking business of the Cooperative Financial Network also saw steady growth, allowing the sharp rise in lending to be funded in full by the increase in deposits from customers.

Equity advanced by 6.0 percent to €104.4 billion as at December 31, 2017 (December 31, 2016: €98.6 billion), thereby breaking through the €100 billion threshold for the first time. This substantial year-on-year increase was achieved despite the persistently difficult operating conditions, once more underlining the sustainability of the Cooperative Financial Network’s successful business model and strengthening its future viability. The sound level of capital adequacy provides the Cooperative Financial Network with a sufficient risk buffer while at the same time enabling it to expand its lending business with retail and corporate customers.

Gains and losses on investments declined to a net loss of €144 million in 2017 (2016: net gain of €33 million). The prior-year figure had received a particular boost from a positive non-recurring item resulting from the sale of shares in VISA Europe.

Other gains and losses on valuation of financial instruments improved from a net loss of €190 million in 2016 to a net gain of €289 million in the reporting year. The main cause of this increase was the narrowing of credit spreads on bonds from the peripheral countries of the eurozone. By contrast, the previous year had seen a widening of these credit spreads.

Net income from insurance business climbed by 14.7 percent to €1,283 million in 2017 (2016: €1,119 million). This year-on-year change in net income arose from the combination of an increase in premium income and a slight decline in insurance benefit payments, which more than offset a fall in the gains and losses on investments held by insurance companies and other insurance company gains and losses, and a rise in the insurance business operating expenses.

Administrative expenses decreased slightly, by 0.3 percent or €60 million, to €17,884 million (2016: €17,944 million). This was primarily due to the cooperative banks’ active management of costs in 2017. The bulk of the administrative expenses were attributable to staff expenses, which came to €10,138 million in 2017 (2016: €10,318 million).

Income taxes amounted to €2,843 million in 2017 (2016: €2,410 million), with most of this amount (€2,649 million) attributable to current income taxes. This underscores the particular importance of the Cooperative Financial Network for Germany’s regional authorities by virtue of it being one of the largest municipal tax payers.

The net profit after tax rose by 3.0 percent to €6,073 million in 2017, compared with €5,898 million in 2016.

The Cooperative Financial Network’s cost/income ratio came to 65.3 percent in 2017 (2016: 67.0 percent).

Corresponding to the change in financial assets held for trading, financial liabilities held for trading fell by €7.4 billion or 16.7 percent to €36.8 billion (December 31, 2016: €44.1 billion). This fall was due, in particular, to an €8.3 billion decline in derivatives (negative fair values) to €16.8 billion. Also within financial liabilities held for trading, however, the volume of bonds issued and other debt certificates issued rose by 1.0 percent to €13.0 billion (December 31, 2016: €12.9 billion).

There was a further strong increase in the Cooperative Financial Network’s equity, which advanced by 6.0 percent to €104.4 billion (December 31, 2016: €98.6 billion). The main reason for this rise was the appropriation of profits generated in 2017 to boost reserves.

Capital adequacy and regulatory ratios

The disclosures relating to own funds and capital requirements are based on the outcome of the extended aggregated calculation in accordance with article 49 (3) of the Capital Requirements Regulation (CRR) in conjunction with article 113 (7) CRR.

The consolidation carried out as part of the extended aggregated calculation demonstrates that by far the greatest proportion of the consolidated own funds consists of the own funds of the primary institutions. The growth in own funds therefore arises primarily from the profits generated by the primary banks and network institutions. Rights issues by the network institutions are for the most part subscribed internally and consolidated within the Cooperative Financial Network.

Due to the exclusion of internal exposures within the network in accordance with article 113 (7) CRR, risk-weighted exposure amounts are generally not consolidated. Consolidation measures primarily include directly and indirectly held own funds instruments within the institutional protection scheme and therefore particularly affect equity investments of primary institutions and subordinate receivables due to them from network institutions, especially from DZ BANK AG. Consolidation measures are based on the corresponding own funds categories (corresponding approach).

Bank operating segment

The net interest income of the Bank operating segment declined by €98 million to €1,525 million in 2017 (2016: €1,623 million).

The net interest margin contribution in the corporate banking business increased again in 2017. Germany’s large and medium-sized companies continued to show a high level of willingness to commit to capital investment in the year under review. By some distance, bank loans remained these companies’ preferred means of covering their financing requirements, which arose principally from the need for expansion investment and funding to cover a rising volume of business. Nevertheless, a sound capital and liquidity position enabled the vast majority of large and medium-sized companies to meet their capital investment requirements from their own cash flows or reserves.

The net interest margin contribution from the development lending business in the Investment Promotion division went up year on year even though the significant downward pressure on margins continued. The main areas of development activity within traditional investment finance were business startups and the implementation of energy efficiency measures in both the residential real estate and agriculture sectors. In spite of this fiercely competitive environment, the aforementioned development lending portfolios expanded.

The main year-on-year changes in the net interest margin contribution from each of the product fields in the Structured Finance division were as follows. In the syndicated business/renewable energies product field, another rise in the net interest margin contribution was achieved, in particular in connection with the funding of wind turbines, in an increasingly competitive environment. The product field also received a boost from spending brought forward in anticipation of consequences from the amendment of the German Renewable Energy Sources Act (EEG 2017). In acquisition finance, large numbers of customers once again made use of the high degree

Allowances for losses on loans and advances in the Bank operating segment increased from €523 million in 2016 to €693 million in 2017. This was mainly due to the spiraling of the crisis in some sections of the shipping industry, the resulting excess capacity, and the challenging situation in offshore finance created by the uncertainty about likely movements in the price of Brent crude going forward.

Net fee and commission income came to €519 million in 2017 and therefore fell short of the prior-year level (2016: €603 million). The service contribution from the corporate banking business declined owing to a reduction in new business. The Investment Promotion division failed to reach the prior-year figure. The main factor influencing the reduction in net fee and commission income in the acquisition finance, project finance, and international trade and export finance product fields was the much fiercer level of competition. By contrast, international documentary business improved markedly. In the asset securitization product field, however, the service contribution was down significantly. The service contribution generated by the Operations/ Services division in 2017 was higher than the equivalent figure reported for 2016 as a result of a rise in the income from securities custody business. Net fee and commission income from lending in the transport finance business was lower in 2017 than it had been in 2016.

The Bank operating segment’s gains and losses on trading activities in 2017 came to a net gain of €485 million, down by €366 million compared with the figure of €851 million for 2016. The markedly larger gain in 2016 was mainly attributable to a positive effect on earnings resulting from liabilities recognized at fair value. Moreover, interest-raterelated changes in the fair value of cross-currency basis swaps used to hedge other transactions amounted to a substantial loss in 2017, whereas they had amounted to a small gain in 2016. In 2016, there had also been income from the reversal of provisions to cover the cost of legal proceedings and attorneys.

Retail operating segment

The net interest income generated by the Retail operating segment amounted to €16,489 million in 2017 and was therefore again slightly lower than the prior-year amount of €16,618 million. In the Retail operating segment, volume growth only partly offset the sustained negative effects of the ECB’s low-interest-rate policy. Moreover, lower contributions to income from LuxCredit foreign currency lending reduced the level of net interest income in 2017. Despite unrelentingly fierce competition and the challenging interest-rate environment, net interest income from consumer finance business increased thanks to buoyant consumer demand throughout the year.

Allowances for losses on loans and advances improved from a net addition of €51 million in 2016 to a net reversal of €95 million in 2017. The risk situation in the Retail operating segment remained stable because the macroeconomic environment was positive.

Net fee and commission income in the Retail operating segment rose significantly, advancing from €6,034 million in 2016 to €6,646 million in the year under review. Net fee and commission income in this segment in 2017 was once again primarily influenced by income from payments processing and strong customer demand in the securities and funds business. As a result of the sustained period of low interest rates, retail investors are increasingly turning to investment products with higher expected returns. The volume-related income contribution generated from the average assets under management rose again year on year and was one of the key drivers for net fee and commission income in the Retail operating segment. There was also an increase in income from performance-related management fees during the reporting period. The contribution to income from the fund services business also improved slightly year on year.

The Retail operating segment’s gains and losses on trading activities were virtually unchanged year on year, amounting to a net gain of €213 million (2016: €211 million). Gains and losses on trading activities are derived from trading in financial instruments, gains and losses on trading in foreign exchange, foreign notes and coins, and precious metals business, and gains and losses on commodities trading.

The level of gains and losses on investments deteriorated by a substantial €80 million to a net loss of €174 million in the reporting year (2016: net loss of €94 million) due to a reduced level of price gains and of reversals of write-downs on securities.

led to a further rise in the prices of commercial real estate in the year under review. Other factors contributing to the uptrend in prices included a greater level of activity in the market, especially by insurance companies and pension funds, and a further shortage of commercial real estate. The upshot was significant downward pressure on commercial real estate margins in 2017, particularly in relation to real estate in prime locations.

The net reversal posted under allowances for losses on loans and advances in the Real Estate Finance operating segment decreased from €45 million in 2016 to a net reversal of €12 million in the year under review.

The net expense traditionally reported for this operating segment under net fee and commission income dropped by €30 million to a net expense of €122 million (2016: net expense of €152 million).

The level of gains and losses on investments in the Real Estate Finance operating segment declined slightly, by €11 million, to reach a net gain of €25 million (2016: net gain of €36 million). The net gain in 2016 was predominantly attributable to the reversal of an impairment loss on a bond of HETA ASSET RESOLUTION AG, Klagenfurt.

Other gains and losses on valuation of financial instruments in the Real Estate Finance operating segment improved significantly year on year, amounting to a net gain of €292 million in 2017 (2016: net loss of €46 million). This increase was mainly caused by a narrowing of credit spreads on bonds from the peripheral countries of the eurozone, whereas credit spreads had widened in 2016.

Administrative expenses rose to €804 million in 2017 (2016: €754 million), mainly due to additional expenses relating to regulatory requirements and strategic projects. Staff expenses fell slightly.

Profit before taxes in the Real Estate Finance operating segment rose by a substantial €436 million to €928 million in the reporting year (2016: €492 million). The performance of the Real Estate Finance operating segment, as outlined above, meant that the cost/income ratio decreased to 46.7 percent (2016: 62.8 percent).

Overall, these developments led, in particular, to lower net foreign exchange gains and a deterioration in unrealized gains and losses. These negative effects were offset mainly by an improvement in realized gains and losses and a fall in impairment losses.

Owing to the inclusion of provisions for premium refunds (particularly in the life insurance and health insurance business) and claims by policyholders in the fund-linked life insurance business, the change in the level of gains on investments held by insurance companies also affected the ‘insurance benefit payments’ line item presented below.

Net insurance benefit payments decreased by 0.6 percent from €15,400 million in 2016 to €15,312 million in 2017.

In line with the change in premium income and in gains and losses on investments held by insurance companies and other insurance company gains and losses, additions were made to insurance liabilities at companies offering personal insurance. Furthermore, an amount of €827 million was added to the supplementary change-in-discount-rate reserve (2016: €626 million).

The increasingly rapid pace of digitalization, which is pervading almost all areas of life, makes it necessary to continually adapt the Cooperative Financial Network’s successful business model. In the years ahead, dealing professionally with new media and IT tools will be included in the job profiles of all bank staff, which means managers and employees need to prepare for the new skill set required in an omnichannel banking environment. New tasks will come to the fore in banks, while others will become less important or even disappear completely. Banks therefore need to plan how many employees they will need, and with what skills, so that they can meet these changing requirements. In view of the evolving job profiles, and also the need to optimize the branch network, systematic personnel management will become a core element of HR work within the individual cooperative banks. This will mean taking account of the banks’ responsibilities as major local employers while also ensuring that they are fully focused on the future.

Anticipatory HR planning was begun in 2016 and continued in 2017. The number of employees fell by roughly 2.5 percent. This was achieved through natural wastage whereby retiring employees were deliberately not replaced. As at December 31, 2017, the number of people employed by the entities in the Cooperative Financial Network (DZ BANK: excluding trainees) totaled 177,248 (see the chart on page 28).

With regard to the digital transformation of the Cooperative Financial Network, an important factor in preparing for the future is the provision of robust inhouse training and continuing professional development (CPD) for trainees. Attracting tech-savvy school leavers to join the banks’ vocational training programs is also crucial. The cooperative banks maintained a good ratio of trainees to other employees of 6.7 percent in 2017 (see the chart on page 30). Launched in 2016, the ‘next’ network for trainees became well-established in 2017. As well as enabling trainees to swap ideas and experiences, the ‘next’ network also serves to recruit new trainees.

The proportion of trainees in the Cooperative Financial Network stood at the high level of 6.3 percent in 2017. The range of apprenticeships and other training offered by the Cooperative Financial Network enables it to compete well with other companies in what is becoming, from the perspective of employers, an increasingly small market of potential trainees. For many years, the Cooperative Financial Network has been one of the most sought-after employers in Germany for school leavers and has held the seal of approval awarded to companies included in ‘Germany’s top 100 employers’. Its appeal has been confirmed by the 2017/18 School Leavers Barometer, a representative survey carried out throughout Germany by the Berlin-based trendence Institute. Many young people see the possibility of obtaining a degree after or alongside their vocational training as an important factor in their choice of employer. For interested young employees, the bachelor degree programs offered through the training providers in the Cooperative Financial Network are a particularly attractive way of gaining further qualifications.

Sustainability – what is it exactly?

Back in 1987, the World Commission on Environment and Development came up with the following definition: “Sustainable development is development that meets the needs of the present generation without compromising the ability of future generations to meet their own needs and to choose their lifestyle.” However, rather than having a onedimensional focus on the future, sustainability encompasses a number of dimensions, as expressed in the guidelines for the German Sustainability Code: “Sustainable business management means looking to the future while balancing social, environmental and economic goals.”

The cooperative principle and self-image

The cooperative banks were founded around 170 years ago on the basis of the cooperative principles of self-help, self-management, and self-responsibility, which were devised by Hermann Schulze- Delitzsch and Friedrich Wilhelm Raiffeisen. To the present day, the cooperative banks have continued to pursue their founding fathers’ principles as widely engaged sponsors and promoters of their regions with utmost commitment and a close connection to their local communities. In memory of their distinguished founder Friedrich Wilhelm Raiffeisen and to honor the values that he promoted, all cooperative banks are commemorating the 200th anniversary of his birth in 2018, which has been designated Raiffeisen Year. After all, Raiffeisen’s ideas are now more alive and relevant than ever before.

Acting in a sustainable manner is a defining characteristic of the cooperative culture. It includes the consideration not only of economic perspectives but also of the environment, community, and society as a whole. Cooperative banks are deeply rooted in society and in their local regions, acting as dependable partners in the establishment of stable economic success over the long term. They have set themselves the goal of combining financial success with a responsible approach to business, in other words assuming responsibility for the development of a positive social framework. Principles such as respect, solidarity, partnership, democracy, decentralization, regionalism, self-responsibility, and helping people to help themselves play a particularly important role in this context. In terms of helping people to help themselves, the cooperative movement has been focused since the outset on improving its members’ financial and thus social circumstances.

The large number of cooperative members in Germany shows that the model of cooperative selfhelp and personal responsibility brings people together, promotes individual commitment, and enables them to get involved in social, cultural, and economic issues and thereby contribute something themselves. The core of the cooperative idea is to generate value for members, provide comprehensive support for associations and foundations, and provide funding for small and medium-sized regional businesses. In addition to support for members and the regional economy, Germany’s local cooperative banks are also strongly committed to the things that matter to their respective regions. Every year, the cooperative banks voluntarily give financial aid of more than €140 million back to their local communities, e.g. by way of donations and sponsorship. The lion’s share of these funds goes toward projects for children and young people and to clubs and associations in the region.

The diverse range of clubs and associations, which have a broad membership base, fits well with the regional focus of the local cooperative banks. In many regions, clubs and associations are the focal point for social interaction and are at the heart of the local community. Nearly all the local cooperative banks also provide regular and extensive support to public-sector institutions such as schools and kindergartens as well as churches and other religious communities.

The total foundation assets of the cooperative banks amount to more than €300 million. Of these funds, €30 million is invested in community and citizens’ foundations. The establishment and promotion of foundations enable the local cooperative banks to create reliable and sustainable funding structures.

The Volksbanken Raiffeisenbanken Cooperative Financial Network again enjoyed a successful year in 2017, enabling it to remain a significant and stable part of the German financial sector. The positive course of business was attributable in large part to the business model with its unwavering focus on customers. The protection scheme run by the BVR (BVR-SE) and BVR Institutssicherung GmbH (BVRISG) 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, guarantee institutional protection and form the backbone of risk management in the Cooperative Financial Network.

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 those required to be members of the protection scheme by law.

Institutional protection scheme of the Cooperative Financial Network

BVR protection scheme

The BVR protection scheme is Germany’s oldest deposit guarantee fund for banks and is financed entirely without government support. Since its creation in the 1930s in the wake of the global economic and banking crisis, it has always ensured that all affiliated banks have been able to meet their financial obligations, particularly with regard to the deposits of retail customers. The protection scheme of the Cooperative Financial Network is therefore the world’s oldest exclusively privately funded and operated deposit guarantee fund for banks. It is regulated and monitored by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) [German Federal Financial Supervisory Authority].

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

The main and unchanged aims of the BVR protection scheme are to safeguard the stability of the member institutions 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 institutions. The BVR manages a guarantee fund and a guarantee network to assist with any supporting measures needed in this connection.

In 2017, the protection scheme met, without qualification, all its responsibilities as a bank-protection scheme in accordance with the articles of association. A total of 926 institutions of the Cooperative Financial Network belonged to the BVR protection scheme as at December 31, 2017 (December 31, 2016: 983 members). The decrease stemmed solely from mergers within the Cooperative Financial Network.

operations can be carried out by the BVR employees who perform the corresponding functions for the BVR protection scheme. Given the long-established successful operation of the BVR protection scheme, this ensures that BVR-ISG can properly carry out its duties as an institutional protection scheme (including classification, collection of contributions, etc.). BVRISG 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.

In 2017, the focus of the activities of BVR-ISG 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, the first 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 2017.

Risk identification and analysis

Basic structures

The Cooperative Financial Network is a decentralized organization made up of legally independent institutions that are linked – through the protection scheme – 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 the BVR protection scheme. 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.

Classification process and contributions to the 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. The protection scheme receives this data electronically from the regional auditing association responsible for the individual bank.

All institutions covered by the protection scheme are included in the classification system. The only exceptions are the small number of institutions that are rated separately by an external rating company, e.g. the central institution and its subsidiaries as well as Münchener Hypothekenbank.

The classification process in 2017 was based on an analysis of data from the 2016 financial statements. There was a small year-on-year improvement in the class distribution based on the 2016 financial statements, primarily due to a slight rise in net assets and a virtually unchanged financial performance. Net interest income went down slightly, whereas net fee and commission income held steady. Fair value gains and losses on the measurement of loans and advances persisted at an exceptionally low level. Non-recurring items in 2016 included the increased reversal of impairment losses on the carrying amount of investments following the merger of the central institutions and the reduced expense for the unwinding of discounts on pension obligations. The net profit generated was used to strengthen the financial position, in particular Tier 1 capital.

For the institutions that are also members of BVR-ISG, the 2017 rate for contributions to the guarantee fund of the protection scheme was set at 0.036 percent of the assessment basis (2016: 0.04 percent), taking account of any individual discounts or surcharges resulting from the classification. For the other member institutions, the contribution rate was 0.0828 of the assessment basis.

Restructuring management

As before, the work of the protection scheme in restructuring member institutions is firstly 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 appropriate measures 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’ forms 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. The protection scheme’s manual is also specifically aimed at banks undergoing preventive measures and any institutions that have themselves identified the need for reorganization. BVRSE finished revising this manual in mid-2017 and all institutions have received the new version.

The BVR protection scheme continued to perform well in the year under review in terms of its restructuring activities. Once again, no new first-time support measures were required in 2017. Costs were therefore incurred solely in connection with legacy cases, where risks already covered had become acute or loss allowances were recognized in the protection scheme’s annual financial statements. As the BVR protection scheme also focused on dealing with and finalizing legacy cases in 2017, the level of restructuring activity fell to an almost immaterial level in the reporting year. The total restructuring amounts in need of protection were not only significantly lower than expected, they were also – on a net basis – again far smaller than the repayments under debtor warrant obligations and other guarantee release obligations. This once more meant that the capital base of the dual cooperative institutional protection scheme (comprising the BVR protection scheme and BVR-ISG) was further strengthened in 2017 and the statutory guarantee fund resources at its disposal could be expanded yet again.

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, 2017 and does not include the retention of the profits reported in the 2017 annual financial statements. Profit is retained after the individual institution’s relevant committees have given their approval. This retention of profits will significantly strengthen the Network’s capital basis still further.

The Cooperative Financial Network’s regulatory total capital ratio was 16.0 percent as at December 31, 2017 (December 31, 2016: 16.1 percent). Overall, regulatory own funds increased by €5.5 billion to €97.7 billion. The increase in own funds was largely attributable to the retention of profits by the primary banks.

The Tier 1 capital ratio improved to 13.4 percent (December 31, 2016: 13.1 percent). If the reserves pursuant to section 340f HGB are classified as Tier 1 capital, the Tier 1 capital ratio is 15.6 percent (December 31, 2016: 15.4 percent). The Cooperative Financial Network’s capital is predominantly held by the primary institutions.

The total risk exposure as at December 31, 2017 amounted to €611.5 billion (December 31, 2016: €572.5 billion). This 6.8 percent increase was driven by growth in the customer lending business, in both the retail and the corporate banking segments.

The protection scheme 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 surcharges (e.g. based on interest-rate risk, other material risks, and/or stress test results).

At business level, the interest-rate and credit risk categories – usually the main risk categories for the local 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 1 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 were again at a manageable level for the banks in 2017, and the surcharges for other material risks fell sharply compared with 2016.

The calculation of risk-bearing capacity, which has previously been mainly based on the going-concern approach in Pillar 2, is undergoing significant changes. Risk-bearing capacity will consist of two pillars in the future. In the normative perspective, the bank needs to identify all applicable statutory provisions on risk-bearing capacity and draw up multi-year capital planning with an adverse scenario. In Pillar 2, the bank’s capital will be measured from a purely economic perspective and compared with the relevant risk profile. The two pillars should communicate with each other. The aim is to secure the bank’s continued existence as a going concern.

Bank management and risk management in the institutions will change as a result of the German banking regulator’s new guidelines, which are based on the ECB’s approach for the Single Supervisory Mechanism (SSM). As well as carrying out additional calculations, the institutions will have to develop a new integrated view of their individual risks by reconciling the two pillars.

Credit risk

Credit risk is the most important risk category in the cooperative banks due to the high volume of lending in the customer business. The cooperative banks manage their credit risk efficiently and sustainably using extensive, high-quality methods of risk measurement. To assess the creditworthiness of individual borrowers, the cooperative banks use the relevant segment-specific VR rating systems, which are validated centrally on an ongoing basis in accordance with high market standards. 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 reviewed 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 cautious 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 2017. Loans and advances to customers increased by 3.9 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. However, residential real-estate prices in Germany continued to go up in 2017. On average across all 402 municipal and rural administrative districts, prices for residential properties rose by 5.4 percent (2016: 4.8 percent).

Market risk

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 reduced by 1.0 percent in 2017. According to analysis, the largest proportion of net interest income was generated from the net interest margin contributions in the customer business, as was the case in prior years. 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.

Along with credit risk, interest-rate risk plays an important role for most of the cooperative banks. The banks could face huge challenges if either the current low level of interest rates continues or there is a rapid and significant rise in interest rates. 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 will come into force in 2018. The new EBA guidelines on managing interest-rate risk in the banking book have been in effect since the beginning of 2016. 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 2, 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 protection scheme 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.

Operational risk

The systems and internal processes implemented by the cooperative banks aim to reduce operational risks that can lead to losses resulting from the inadequacy or failure of internal processes, people, or systems or as a consequence of external events.

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.

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 Cooperative Financial Network’s digitalization initiative 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.

Measures derived from the KundenFokus 2020 (customer focus 2020) project have been implemented in order to take account of the changes in customer behavior and to adjust and strengthen the business model accordingly. Personal contact will remain 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 efficient 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.

Germany’s economic upturn is likely to continue in 2018. In this year’s spring report, experts at the leading economic research institutions predict that GDP adjusted for inflation will rise by 2.2 percent, the same rate as 2017.

The spring report’s forecast for the performance of the German economy as a whole is based on various assumptions. Firstly, it assumes that global trade will grow at a slightly faster pace in 2018 than in 2017, the oil price will increase a little, and the euro/ US dollar exchange rate will remain unchanged at around US$ 1.20. The second assumption is that the measures agreed in the new German government’s coalition agreement, for example the planned lowering of the contribution rate for unemployment insurance, will stimulate growth.

According to the spring report, the global economic environment will continue to boost German exports. Domestic demand is also likely to maintain its momentum. In the labor market, the economists anticipate that the increase in employment levels will slow down due to the growing shortage of workers. They predict that the number of people in employment will go up by 585,000 in 2018, while the unemployment rate will fall to 5.2 percent. Consumer prices are forecast to continue rising moderately, leading to a probable inflation rate of 1.7 percent.

The economists believe that the main risks to the economic conditions outlined above are at international level. A particularly significant risk is the concern about growing protectionism, which could have a marked adverse impact on the growth of the global and thus the German economy. In June 2018, for example, the US government began applying the tariffs on steel and aluminum from EU member states that it had announced at the start of the year. This led to considerable uncertainty about future trade policies and dampened economic sentiment. However, it is also conceivable that the trade conflict will not escalate or may even be quickly resolved. In this case, the uncertainty could dissipate rapidly and global economic growth could pick up.

With regard to the monetary policy of the ECB, the experts at the economic research institutions expect the central bank to incrementally scale back its highly expansionary approach. The ECB has announced that it will terminate its bond-buying program at the end of 2018. However, it does not anticipate raising the key interest rate, which has stood at 0.0 percent since March 2016, until the end of 2019. Consequently, yields on German government bonds with long maturities will probably remain very low by historical standards.

Since the financial crisis, the financial sector has faced considerable pressure in terms of both adjustment and costs caused by the need to comply with regulatory reforms – involving higher capital requirements and changes to regulatory systems – and implement structural change to adapt to competitive conditions.

In addition to the new regulatory environment, new competitors with approaches based on the use of data and technology are presenting the financial sector with the challenge of scrutinizing its existing business models, adapting them as required, and substantially improving its efficiency by digitalizing business processes and IT processes. The resulting capital investment is initially likely to lead to substantial costs before the anticipated profitability gains can be realized.

Moreover, the outlook for the business performance of the Cooperative Financial Network shows that 2018 will also be influenced by the low level of interest rates.

The expected growth in large swathes of the global economy should provide a boost for the financial performance of the Cooperative Financial Network. In this context, however, it is important not to disregard the negative factors for global economic growth resulting not only from Brexit but also from current trade restrictions and possible new ones in the future. These factors could also depress the heavily export-oriented German economy, although small and medium-sized enterprises have less of a focus on exports.

These factors may thus limit the growth of the Cooperative Financial Network’s income and thus its latitude for accumulating capital in 2018. Nevertheless, the Cooperative Financial Network is expected to generate a satisfactory level of earnings this year by exploiting market opportunities in its core business areas and, at the same time, actively managing costs. This will enable it to further strengthen its reserves.

Net gains under gains and losses on investments in 2018 are predicted to make a modest contribution to profit before taxes because the non-recurring items recognized in 2017 will not be repeated.

Other gains and losses on valuation of financial instruments are expected to follow a positive trend in 2018, mainly due to the potential that exists to reverse impairment losses in the portfolios of instruments from government issuers in the Real Estate Finance segment. Volatility in capital markets and the widening of credit spreads on securities from government issuers could have an adverse impact on the forecast improvement in these gains and losses.

Net income from insurance business is expected to contract in 2018. Given the expected growth in the gross premiums from the different divisions, the decline in net income is expected to be caused by a deterioration in gains and losses on investments held by insurance companies, reflecting the current environment of low interest rates. Exceptional events in financial and capital markets, changes in underwriting practices, or potential changes in the regulatory requirements faced by insurers may mean that net income from insurance business falls short of expectations.