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

The Volksbanken Raiffeisenbanken Cooperative Financial Network consists of 875 cooperative banks (2017: 915), the DZ BANK Group, Münchener Hypothekenbank eG, the BVR protection scheme, and BVR Institutssicherung GmbH as consolidated entities. The consolidated cooperative banks include Deutsche Apothekerund Ärztebank eG, the Sparda banks, the PSD banks, and specialized institutions such as BAG Bankaktiengesellschaft.

The cooperative banks and Münchener Hypothekenbank eG are the legally independent, equally ranked parent entities of the Cooperative Financial Network, whereas the other banking groups and entities are consolidated as subsidiaries.

The pace of growth in the German economy slowed markedly in 2018. Adjusted for inflation, gross domestic product (GDP) rose by 1.4 percent year on year, compared with 2.2 percent in 2017.

Factors on both the demand side and the supply side contributed to this weakening of growth. On the one hand, companies increasingly faced supply-side shortages, primarily of workers and intermediate goods. Moreover, manufacturing was impacted by one-off factors such as strikes, a severe flu epidemic in the early part of 2018, and a backlog of new car registrations (caused by problems with the new Worldwide Harmonised Light Vehicles Test Procedure, WLTP), which weighed heavily on macroeconomic output in the second half of the year. On the other hand, global trade lost some of its momentum compared with the previous year, which took its toll on demand.

The main reasons for the slower pace of global trade were that global economic growth had peaked and trade relations had deteriorated. The latter was predominantly due to the US government’s trade policy, with US President Donald Trump progressively imposing new tariffs on the import of various products, including steel and aluminum. The affected trading partners – above all China, but also European countries – responded with retaliatory tariffs of their own. Nevertheless, Germany’s economic growth was only slightly dented by the trade disputes, not least because domestic demand carried on expanding robustly.

Spending on capital equipment, for example, continued to go up thanks to higher capacity utilization in the manufacturing sector and because funding terms remained extremely favorable.

Business situation

In a difficult market environment shaped by the ECB’s long-standing policy of low interest rates and the continuation of fierce competition, combined with the influence of demanding regulatory requirements, the Volksbanken Raiffeisenbanken Cooperative Financial Network had yet another successful year in 2018. Profit before taxes amounted to €7,771 million, which fell short of the excellent prior-year figure of €8,916 million. With its focus on value creation and customers, the regionally oriented business model of the Cooperative Financial Network nevertheless again proved robust and reliable in these difficult operating conditions. This was clearly demonstrated by the fact that the Cooperative Financial Network’s core operating business generated a very stable level of income that was on a par with 2017. The decrease was largely attributable to turmoil in the capital markets at the end of 2018 and the related falls in securities prices.

In 2018, 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 5.5 percent, which was only just short of the 2017 growth rate of 5.6 percent. The main driver of this sustained growth in the lending business was again brisk customer demand for long-term home loans, which was supported by low interest rates on loans, rising incomes, and the positive trends in the labor market. 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 a little higher. The Cooperative Financial Network’s deposit-taking business continued to see stable and granular growth, contributing to the funding of its expanding lending business.

Equity advanced by 3.2 percent to €107.7 billion (December 31, 2017: €104.4 billion). This figure underlines the sustainability and future viability of the Cooperative Financial Network. The sound level of capital adequacy provides the Cooperative Financial Network with a sufficient risk buffer while, at the same time, enabling it to seize opportunities for expanding its lending business with retail and corporate customers.

Gains and losses on investments deteriorated significantly to a net loss of €913 million (2017: net loss of €144 million). This decrease largely resulted from higher write-downs on securities than in the previous year.

Loss allowances, which were determined in accordance with IFRS 9 for the first time in 2018, amounted to a net addition of €151 million (2017: net addition of €576 million).

Other gains and losses on valuation of financial instruments declined from a net gain of €289 million in 2017 to a net loss of €122 million in the reporting year, predominantly due to the widening of credit spreads. By contrast, the previous year had seen a narrowing of these credit spreads.

The net income from insurance business omprises premiums earned, gains and losses on investments held by insurance companies and other insurance company gains and losses, insurance benefit payments, and insurance business operating expenses. In 2018, this figure decreased by 32.7 percent to €863 million (2017: €1,283 million). This year-on-year change was attributable to a significant fall in gains and losses on investments held by insurance companies and other insurance company gains and losses.

Despite the objective of reducing administrative expenses, they rose slightly in the year under review, by 1.1 percent or €195 million, to €18,079 million (2017: €17,884 million). The bulk of the administrative expenses were attributable to staff expenses, which came to €10,076 million (2017: €10,137 million), and general and administrative expenses, which amounted to €7,011 million (2017: €6,793 million).

Income taxes amounted to €2,369 million in 2018 (2017: €2,843 million), with most of this amount €2,731 million (2017: €2,649 million) attributable to current income taxes. This underscores the particular importance of the Cooperative Financial Network for Germany’s regional authorities, given that it is one of the largest municipal tax payers.

Net profit after tax fell by 11.0 percent to €5,402 million in 2018, compared with €6,073 million in 2017.

The Cooperative Financial Network’s cost/income ratio came to 69.5 percent in 2018 (2017: 65.3 percent).

On the equity and liabilities side of the balance sheet, deposits from customers again grew markedly, rising from €801.0 billion as at December 31, 2017 to €842.4 billion as at December 31, 2018. Deposits from banks also increased, by 5.5 percent, to reach €119.3 billion (December 31, 2017: €113.1 billion).

Financial liabilities held for trading rose by €5.7 billion or 15.5 percent to €42.5 billion (December 31, 2017: €36.8 billion). This was largely due to the 55.4 percent increase to €20.3 billion in the volume of bonds issued including share- and index- and other debt certificates issued (December 31, 2017: €13.0 billion). Conversely, derivatives (negative fair values) declined by €0.7 billion to €16.1 billion and liabilities by €1.3 billion to €5.0 billion.

The Cooperative Financial Network was again able to report a robust level of equity, which advanced by 3.2 percent to €107.7 billion (December 31, 2017: €104.4 billion). The main reason for this rise was the appropriation of profits generated in 2018 to boost reserves. This growth strengthens the Cooperative Financial Network and gives it scope to continue expanding the lending business and to invest for the future.

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 cooperative banks. The growth in own funds therefore arises primarily from the profits generated by the cooperative 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

The operating segments ‘Retail Customers and SMEs’ and ‘Central Institution and Major Corporate Customers’ were previously called ‘Retail’ and ‘Bank’. Their composition has not changed.

Retail Customers and SMEs operating segment (2017: ‘Retail’)

The net interest income generated by the Retail Customers and SMEs operating segment amounted to €16,321 million in 2018 and was therefore again lower than the prior-year amount (2017: €16,489 million ). In the Retail Customers and SMEs operating segment, volume growth only partly offset the sustained negative effects of the ECB’s low-interest-rate policy. The volume of LuxCredit foreign currency lending was almost at the level of the prior year. Net interest income from consumer finance business rose once again thanks to a significant consumer propensity to buy goods and services and take on finance, fueled by the stability of the German economy along with low interest rates and rising real wages.

Net fee and commission income rose significantly, advancing from €6,646 million in 2017 to €6,918 million in the year under review. Net fee and commission income in the Retail Customers and SMEs operating segment in 2018 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 backed by real estate and tangible assets to supplement their interest-related investments. The volume-related income contribution generated from the average assets under management was one of the key factors in the increase in net fee and commission income in the Retail Customers and SMEs operating segment. However, income from performance-related management fees and from real estate fund transaction fees fell short of the amounted generated in 2017. The contribution to income from the fund services business also improved a little year on year, whereas the volume of assets under management relating to high-net-worth clients was down slightly.

As a result of the factors described above, the profit before taxes of the Retail Customers and SMEs operating segment fell from €8,088 million in 2017 to €6,208 million in 2018. Accordingly, the cost/income ratio increased by 2.6 percentage points to 68.2 percent (2017: 65.6 percent).

Central Institution and Major Corporate Customers operating segment (2017: ‘Bank’)

The net interest income of the Central Institution and Major Corporate Customers operating segment declined again, by €154 million, to €1,371 million in 2018 (2017: €1,525 million).

The Cooperative Financial Network’s corporate banking business has been pivotal in supporting the sustained economic upturn that began some years ago. Over the past few years, the volume of lending has consistently grown at a much faster rate than that of the market as a whole, enabling a sharp rise in the network’s share of the corporate customer lending market. Although economic growth slowed in 2018, the German economy remains robust and is thus making a key contribution to net interest income in the Central Institution and Major Corporate Customers operating segment. At the same time, however, the increasingly challenging competitive environment continues to put pressure on credit margins. Both digitalization and the shift in customer behavior are intensifying the need for innovation and optimization in corporate banking. The sound capital and liquidity position of the majority of large and medium-sized companies enables them to meet their capital investment requirements from their own cash flows or reserves rather than take out loans.

Net interest income also decreased in the money and capital markets business due to portfolio contraction resulting from the shortening of the duration of own-account investments. The adverse impact of subordinated capital diminished as a consequence of the decrease in liabilities-side business.

In the transport finance business, the prior year had been significantly affected by special accelerated depreciation allowances on assets subject to operating leases. The international transport industry again experienced overcapacity within some segments of the international maritime shipping market in 2018, resulting in sharply falling freight rates and considerable downward pressure on ship prices.

The level of gains and losses on investments improved from a net loss of €17 million in 2017 to a net gain of €195 million in the reporting year as a result of gains from the disposal of securities in the liquidity pool. Some of these gains were offset by losses arising from the termination of hedges in the context of portfolio fair value hedge accounting.

In the transport finance business, the figure for the prior year had notably been affected by impairment losses recognized in respect of equity-accounted entities. The figure for 2018 predominantly comprised gains on the sale of an equity-accounted investment.

Loss allowances, which were determined in accordance with IFRS 9 for the first time in 2018, amounted to a net reversal of €70 million in the reporting year compared with a net addition of €693 million in 2017. This positive trend was predominantly due to borrowers’ rating improvements and successful restructuring and recovery measures, but also to the generally lower loss allowance requirement in the transport finance business.

Other gains and losses on valuation of financial instruments deteriorated to a net loss of €79 million in 2018 (2017: net loss of €10 million) as a result of market conditions. This decrease was mainly attributable to IFRS-related measurement effects relating to hedge accounting and to interest-rate-related measurements of cross-currency swaps.

Administrative expenses went down by €25 million to €1,944 million in the period under review (2017: €1,969 million). In 2017, this item had still been adversely affected by merger-related expenses in connection with the migration of data. The Central Institution and Major Corporate Customers operating segment was able to make savings on its staff expenses in 2018 due to reduced expenditure on variable remuneration. These savings were partly offset by higher expenses for the bank levy and by increased project-related consultancy and IT expenses.

Profit before taxes in the Central Institution and Major Corporate Customers operating segment climbed by €524 million year on year to €431 million (2017: loss of €93 million) due to the factors described above. The cost/income ratio rose from 76.6 percent in 2017 to 84.3 percent in the reporting year.

The net reversal posted under loss allowances in the Real Estate Finance operating segment decreased from €12 million in 2017 to €2 million in the year under review.

Other gains and losses on valuation of financial instruments in the Real Estate Finance operating segment deteriorated significantly year on year, amounting to a net loss of €16 million in 2018 (2017: net gain of €292 million). This decrease was mainly caused by a widening of credit spreads on bonds from the peripheral countries of the eurozone in the mortgage lending business, whereas credit spreads had narrowed in 2017.

Administrative expenses rose to €885 million in 2018 (2017: €804 million). This increase was mainly due to additional expenses for consultancy and IT costs in relation to strategic projects as well as measures to enhance the Real Estate Finance operating segment.

Profit before taxes in the Real Estate Finance operating segment fell by a substantial €451 million to €477 million in the reporting year (2017: €928 million). The performance of the Real Estate Finance operating segment, as outlined above, meant that the cost/income ratio rose to 65.1 percent (2017: 46.7 percent).

Insurance operating segment

Net premiums earned went up by €816 million to €15,997 million (2017: €15,181 million), reflecting the integral position held by the R+V subgroup within the Cooperative Financial Network. This exceeded the level of premiums earned in 2017 by 5.4 percent. Gross premiums written increased by 5.2 percent to €16,133 million in the year under review (2017: €15,338 million), also surpassing the excellent level of premiums written in 2017.

Premium income in the life insurance and health insurance business grew by a total of 3.2 percent to €7,868 million. In the life insurance business, premiums rose markedly, by 2.9 percent, to €7,273 million. This growth was predominantly attributable to higher one-off premiums, particularly in the Neue Garantien and bAV (occupational pensions) product lines, whereas premiums from products in the classic and unit-linked businesses declined.

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 and losses on investments held by insurance companies also affected the ‘insurance benefit payments’ line item presented below.

Net insurance benefit payments decreased by 7.2 percent from €15,312 million in 2017 to €14,208 million in 2018. At the companies offering personal insurance, the changes in insurance benefit payments were 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. An amount of €305 million (2017: €827 million) was added to the supplementary change-in-discountrate reserve. The ‘corridor method’ for calculating the supplementary change-in-discount-rate reserve was introduced in accordance with the German Regulation for Amending the Regulation on the Principles Underlying the Calculation of the Premium Reserve (DeckRV), which came into force on October 23, 2018. This method changed the procedure for determining the reference discount rate in order to restrict excessive changes under the previous rules. The corridor method was applied retrospectively for the whole of 2018 for those R+V Group companies offering personal insurance that were affected.

The financial sector faces huge challenges as a result of far-reaching changes in its environment. The transformation into a digital world, a shift in customers’ expectations, and the transition to an information society with the postulate ‘life-long learning’ all place new demands on employees and managers, including in the Cooperative Financial Network. Moreover, there have been changes among employees across all age groups about what they expect from their immediate working environment.

It is increasingly recognized that the digital transformation can only be effective if the implementation of new technologies is accompanied by a fundamental cultural shift at the individual banks. This cultural evolution starts with the broad-based use of digital media but also encompasses internal communications and necessitates both a revised approach to management and increased flexibility in terms of working hours and location. From a human resources perspective, banking of the future at the cooperative banks will require employees and managers to be well-versed in the use of digital applications, to be open to the opportunities of digitalization, and to practice a measured risk culture when it comes to dealing with these new areas. A high level of willingness to embrace change at every level and having the necessary organizational structures in place are crucial if the individual bank is to successfully equip itself for the future.

In this process, the cooperative banks are supported by a comprehensive range of products and services from the cooperative associations, academies, and service providers. Specially designed professional development activities are available for employees, managers, and members of boards of managing directors that help to equip them for this upcoming transformation.

Human resources activities at the level of the individual cooperative banks also need to change. The focus is not only on improving the efficiency of human resources work by deploying suitable IT tools but also on sharing the work more widely with HR service providers within the Cooperative Financial Network and, in particular, on increasing the HR expertise of staff in the department. For this reason, the Bundesverband der Deutschen Volksbanken und Raiffeisenbanken e.V. (BVR) [National Association of German Cooperative Banks] launched a project relating to human resources work of the future in 2018. The objectives of the project are as follows:

• Formulation of a new strategic blueprint for future human resources work so that the cooperative banks can continue to cater to the changing requirements faced by their workforce

• Incorporation of the products and services of the cooperative HR service providers into this strategic blueprint for future human resources work

If a cooperative bank’s workforce is to be a key factor in the information society, then human resources activities will also take on a fundamental role by making an invaluable contribution to the institution’s efforts to equip itself for the future.

For many years, the idea of sustainability has been a guiding light for politicians, businesspeople, and environmentalists. One of the most widely used definitions of the term sustainability is the one developed by the United Nations in 1987: “Sustainable development is development that meets the needs of the present generation without compromising the ability of future generations to meet their own needs.” According to this definition, sustainable development refers both to the present and to the future. The Cooperative Financial Network promotes sustainable development from an economic, social, and environmental perspective.

Owners: achieving more together

The identity principle is what makes the cooperative different from all other types of company structure. Its members are also its owners and customers. More than half of its customers have proactively decided to become a member. The cooperative banks have 18.6 million members across Germany. The cooperative banking remit to provide development finance entails collaboration in a spirit of partnership aimed at mutual benefit. It also defines the ethical business context: According to section 1 of the German Cooperative Act (GenG), the nature of the business has to be oriented to the long-term success of its members. Partnership, self-responsibility, and helping people to help themselves are thus part of the cooperative DNA.

Cooperative advocacy, along with the annual general meeting or general assembly of representatives and the supervisory board (whose members are businesspeople from the region), ensures opportunities for involvement in the democratic process and encourages dialog within society on economic, social, and environmental issues. At the same time, the local cooperative banks learn from the collaboration with their cooperative governing bodies, adopt business innovations, and embrace changing requirements in order to put their business models on an efficient footing for the future in line with market needs.

Regional responsibility

In accordance with their remit to provide development finance, the cooperative banks independently align the nature of their business to the long-term success of their members and customers, taking a grass-roots democracy approach. A responsible business policy with a strong focus on members and on the common good is thus an integral element of their corporate strategy. For more than 170 years, they have been supporting, encouraging, and advising local people and companies through their financial services and playing a vital role for the real economy through responsible lending. They operate and do business on the basis of mutuality: Each cooperative bank belongs to its members, who benefit from the strength and solidarity of a powerful community. Moreover, an annual dividend enables members to share directly in the business success of the cooperative banks.

The local cooperative banks have always adhered to the principle of sustainability and pass on their economic success to the regions in which they operate.

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. 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. BVR-SE 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, BVR-SE has been continued as an additional voluntary bank-protection scheme in accordance with section 2 (2) and section 61 EinSiG.

The main and unchanged aims 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 2018, BVR-SE met, without qualification, all its responsibilities as a bank-protection scheme in accordance with the articles of association. A total of 885 institutions of the Cooperative Financial Network belonged to BVR-SE as at December 31, 2018 (December 31, 2017: 926 members). The decrease stemmed solely from mergers within the Cooperative Financial Network.

day-to-day business operations can be carried out by the BVR employees who perform the corresponding functions for BVR-SE. Given the long-established successful operation of BVR-SE, this ensures that BVR-ISG can properly carry out its duties as an institutional protection scheme (including classification, collection of contributions, etc.). 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 2018 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 2018.

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.

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 2018 was based on an analysis of data from the 2017 financial statements. There was another year-on-year improvement in the class distribution that was attributable to a further small boost to the risk position, a virtually unchanged level of net assets, and a slightly poorer financial performance across the network as a whole. Adjusted for non-recurring items, net interest income went down only slightly, whereas net fee and commission income rose and the cost/income ratio held more or less steady. Loss allowances for loans and advances were exceptionally low, as had been the case in previous years. There was a slight drop in the proportion of unsecured lending classed as loans with a high probability of default or as non-performing loans (NPLs).

The net profit generated was used to strengthen the financial position, in particular Tier 1 capital.

For the institutions that are also members of BVRISG, the 2018 rate for contributions to the guarantee fund of the protection scheme was set at 0.036 percent of the assessment basis (unchanged on 2017), taking account of any individual discounts or surcharges resulting from the classification. For the other member institutions, the contribution rate was 0.0828 percent of the assessment basis.

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, appropriate measures are agreed that are aimed at stabilizing and improving their business performance.

required in 2018. Costs were therefore incurred solely in connection with legacy cases, where risks already covered had become acute or loss allowances were recognized in BVR-SE’s annual financial statements. As BVR-SE also focused on dealing with and finalizing legacy cases in 2018, 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 meant that the capital base of the dual cooperative institutional protection scheme (comprising BVR-SE and BVR-ISG) was strengthened once again in 2018 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

In financial terms, BVR-SE expects the cooperative banks’ performance to be unchanged or to weaken slightly in 2019. At present, there is no sign of any scenarios that might present a material threat to the stability of BVR-SE. Particularly in view of the slowing German economy, however, an increase in the level of support and assistance provided by BVR-SE cannot – for the first time in five years – be ruled out in 2019. In light of this potential adverse development, BVR-SE plans to strengthen its guarantee fund capital in the next few years.

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, 2018 and does not include the retention of the profits reported in the 2018 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 capital base still further in 2019.

The Tier 1 capital ratio improved to 13.6 percent (December 31, 2017: 13.4 percent). If the reserves pursuant to section 340f of the German Commercial Code (HGB) are classified as Tier 1 capital, the Tier 1 capital ratio was unchanged year on year at 15.6 percent. The Cooperative Financial Network’s regulatory total capital ratio was 15.8 percent as at December 31, 2018 (December 31, 2017: 16.0 percent). Overall, regulatory own funds increased by €4.0 billion to €101.7 billion. The rise in own funds was largely attributable to the retention of profits from 2017 by the cooperative banks, which was reflected in the ratios as at December 31. The Cooperative Financial Network’s capital is predominantly held by the cooperative banks.

The total risk exposure as at December 31, 2018 amounted to €642.4 billion (December 31, 2017: €611.5 billion). This 5.1 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 on page XX, the

business activities, and size of the bank. The banks receive procedural support through the VR Control concepts 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 new requirements of the Internal Capital Adequacy Assessment Process (ICAAP). The BVR drew up the necessary integrated concept in the VR Control update project, and it will be made available to the banks in 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 were again at a manageable level for the banks in 2018, and the surcharges for other material risks fell sharply compared with 2017.

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) 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 took 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 banks to tackle

Credit risk

Credit risk in the customer business is the most important risk category in the cooperative banks. 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 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 2018. Loans and advances to customers increased by 4.3 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 2018. On average across all 401 municipal and rural administrative districts, prices for purchasing residential properties for own use rose by 5.9 percent (2017: 5.4 percent). The price rises were geographically well distributed in 2018, with increases in both urban and rural areas.

in 2018. 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.

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 purpose of determining the shortfalls/volatility, parcIT provides generic interest-rate scenarios (VR interest-rate scenarios) centrally that are derived from time series. They contain not only parallel shifts but also rotations of the yield curve. 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 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

(NSFR). They have business management tools at their disposal that enable the bank-specific parameterization of the funding matrices using the banks’ own behavior-based assumptions and the calculation of a transaction-based liquidity price that can then be factored into their contribution costing as appropriate. The individual cooperative banks are thus able to establish and manage an appropriate level of liquidity adequacy.

With the BVR taking a leading role, the necessary plans were drawn up and then signed off by the relevant committees in 2018. A systemic rollout to support the concept is taking place in 2019.

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 at December 31, 2018, the median LCR of all cooperative institutions was 165.7 percent (December 31, 2017: 161.3 percent).

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.

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).

Measures derived from the KundenFokus (customer focus) project have been implemented 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 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 economy has been turning noticeably gloomier since summer 2018. This is due not only to the more challenging global economic conditions but also to two one-off factors. Firstly, introduction of the new Worldwide Harmonised Light Vehicles Test Procedure (WLTP) resulted in a backlog of new car registrations. Secondly, the exceptionally dry summer led to low water levels in Germany’s rivers and canals, causing disruptions for ship transport. The disappearance of these one-off factors should enable the overall economy to pick up again in the first half of 2019. The BVR’s model-based estimates show that the economy is unlikely to slip into recession. However, economic growth is expected to remain muted for the time being. This can be seen from important sentiment indicators, such as the ifo Business Climate Index, which have not staged much of a recovery from their downturn last year, despite the brightening situation at the start of 2019.

In its latest economic main scenario (dated June 2019), the BVR predicts that, adjusted for inflation, GDP will rise by 0.8 percent in 2019. Growth is therefore expected to be significantly weaker than in 2018. As was the case last year, rising consumer spending and capital expenditure will remain the main growth drivers. These two types of spending will be underpinned by factors such as the continued increase in employment, (in many cases) rapidly rising income levels, the sustained health of the construction industry, and expansionary fiscal policy measures introduced by the German government. However, foreign trade is likely to hold back the increase in GDP, as exports will probably grow at a slower rate than imports. Consumer prices are predicted to rise by 1.4 percent.

As at June 2019, the downside risks for the economy are considerably greater than the prospects of an upturn. The risks primarily emanate from the global situation and are predominantly political in nature. If, for example, the US government imposes new tariffs on vehicles imported from the EU, there is likely to be a severe impact on German foreign trade. It is also unclear whether the weakness of the German automotive industry, which took a heavy toll on the country’s economic growth in the second half of 2018, was solely caused by the one-off effect of introducing the WLTP. Structural factors were

bonds, and uncertainties surrounding the tariffs to be imposed by the US government and by China. The ongoing difficulties in respect of income from interest-earning business will continue to be affected by the level of interest rates in the eurozone, which is not appropriate to the economic conditions, and margins will again be significantly squeezed over the course of 2019. These difficulties are still being mitigated at present by the low number of insolvencies among companies and individuals across Germany and by the country’s sustained economic upturn, albeit at a diminishing rate. From the current perspective, no significant increase in the need to recognize loss allowances for loans and advances is expected in 2019. The extent of fair value gains and losses in the securities portfolio depends heavily on possible market turmoil, which is also significantly influenced by the aforementioned political risks.

In 2019, banks are continuing to address this still-growing pressure on earnings and the highly adverse impact of regulatory requirements by taking steps to improve their efficiency with the aim of reducing costs. There will continue to be mergers for economic reasons, and reviews of the appropriateness of the branch networks remain on the agenda. The main driver here continues to be changing customer behavior, with people increasingly accessing banking products online. Advancing digitalization will also further reduce the number of employees needed in the financial sector.

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 Cooperative Financial Network shows that the environment of low interest rates will continue to dominate business performance and that the aforementioned challenges will have an adverse impact.

The expected growth in parts of the global economy should provide a boost for the financial performance of the Cooperative Financial Network. It is important, however, not to forget the negative factors for global economic growth resulting not only from Brexit but also from possible trade restrictions. These factors could also depress the heavily export-oriented German economy.

These challenges may thus limit the growth of the Cooperative Financial Network’s income and thus its latitude for accumulating capital in 2019. Nevertheless, the Cooperative Financial Network is expected to generate a satisfactory level of earnings overall this year by exploiting market opportunities in its core business areas and, at the same time, actively managing costs. This should enable it to further strengthen its reserves.

Net interest income, particularly in the Retail Customers and SMEs operating segment, will remain under pressure in 2019, primarily as a consequence of the persistently low interest rates.

The Cooperative Financial Network anticipates that net fee and commission income will hold steady in 2019. Any lasting uncertainty in capital and financial markets could have a negative impact on confidence among retail and institutional investors, thereby depressing net fee and commission income.

In 2019, gains and losses on trading activities, which are particularly influenced by those of the Central Institution and Major Corporate Customers operating segment, are expected to be at a much better level than in 2018.