Credit Opinion: Volvofinans Bank AB

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Credit Opinion: Volvofinans Bank AB

Global Credit Research - 17 Dec 2015

Gothenburg, Sweden

Ratings

Category Moody's Rating

Outlook Stable

Bank Deposits A3/P-2

Baseline Credit Assessment baa2 Adjusted Baseline Credit Assessment baa2 Counterparty Risk Assessment A2(cr)/P-1(cr)

Contacts Analyst Phone Giovanni Fontana/London 44.20.7772.5454 Sean Marion/London Aleksander Henskjold/London Key Indicators

Volvofinans Bank AB (Unconsolidated Financials)[1]

[2]9-15 [2]12-14 [3]12-13 [3]12-12 [3]12-11 Avg.

Total Assets (SEK million) 29,692.9 29,299.4 29,863.2 28,643.6 29,489.4 [4]0.2 Total Assets (EUR million) 3,171.6 3,093.1 3,374.4 3,339.7 3,313.7 [4]-1.1

Total Assets (USD million) 3,540.3 3,742.8 4,649.7 4,403.0 4,301.7 [4]-4.8

Tangible Common Equity (SEK million) 3,460.3 3,421.3 3,375.9 3,042.4 3,006.9 [4]3.6 Tangible Common Equity (EUR million) 369.6 361.2 381.5 354.7 337.9 [4]2.3 Tangible Common Equity (USD million) 412.6 437.0 525.6 467.7 438.6 [4]-1.5

Problem Loans / Gross Loans (%) 0.5 0.6 0.7 0.6 0.9 [5]0.7 Tangible Common Equity / Risk Weighted Assets (%) 24.6 24.8 21.1 18.6 17.4 [6]24.7

Problem Loans / (Tangible Common Equity + Loan Loss Reserve) (%)

3.4 4.5 4.8 4.9 7.3 [5]5.0

Net Interest Margin (%) 1.3 1.2 1.0 1.0 -- [5]1.2 PPI / Average RWA (%) 2.9 2.3 1.7 1.5 1.4 [6]2.6 Net Income / Tangible Assets (%) 1.0 0.9 0.7 0.6 0.7 [5]0.8 Cost / Income Ratio (%) 42.9 48.2 52.9 54.0 50.5 [5]49.7

Market Funds / Tangible Banking Assets (%) 33.5 33.6 33.0 39.4 57.5 [5]39.4

Liquid Banking Assets / Tangible Banking Assets (%) 11.0 12.9 17.2 11.7 8.8 [5]12.3

Gross loans / Due to customers (%) 184.1 180.6 168.2 206.1 353.0 [5]218.4

Source: Moody's

[1] All figures and ratios are adjusted using Moody's standard adjustments [2] Basel III - fully-loaded or transitional phase-in; IFRS [3] Basel II; IFRS [4] Compound Annual Growth Rate based on IFRS reporting periods [5] IFRS reporting periods have been used for average calculation [6] Basel III - fully-loaded or transitional phase-in & IFRS reporting periods have been used for average calculation

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SUMMARY RATING RATIONALE

We assign a baa2 baseline credit assessment (BCA) and A3 long-term deposit ratings to Volvofinans Bank. We also assign a long-term and short-term counterparty risk assessment (CRA) of A2(cr)/Prime-1(cr) to the bank.

Volvofinans' baa2 BCA reflects (i) the bank's solid market share in car and truck financing in Sweden, (ii) consistently good asset quality, (iii) increasingly higher capitalisation and (iv) decreasing albeit high reliance on market funding. More negatively, the BCA also captures (i) the bank's car-sector concentration, (ii) moderate, yet predictable profitability (iii) the bank's reliance on market funding.

RATING DRIVERS

- Volvofinans Bank's BCA is supported by its Very Strong- Macro Profile

- Stable franchise position in Sweden

- Profitability is stable although it lags leading Swedish banks

- Deposits replacing wholesale funding

- Asset quality is good although the bank focuses on car financing

- Capital position is good but equity investor base is likely small

RATING OUTLOOK

The outlook on Volvofinans's deposit ratings is stable.

WHAT COULD CHANGE THE RATING - UP

We could upgrade Volvofinans's BCA if the bank strengthened its profitability without accumulating more credit risk whilst simultaneously maintaining its strong capital position and reducing its reliance on market funding.

WHAT COULD CHANGE THE RATING - DOWN

A downgrade of the BCA could follow (i) a deterioration of asset quality that for example could result from

increased unsecured consumer lending, (ii) a deterioration in profitability, (iii) materially increased use of short-term wholesale funding and/or, (iv) a materially smaller cushion of liabilities eligible for bail-in.

DETAILED RATING CONSIDERATIONS

The financial data in the following sections are sourced from Volvofinans's financial statements unless otherwise stated.

VOLVOFINANS BANK'S BCA IS SUPPORTED BY ITS VERY STRONG- MACRO PROFILE

Sweden's Macro Profile benefits from a competitive and diverse economy, robust public institutions and a stable political environment that supports consensus orientated policy making. However, we view Swedish households' debt levels (80% of which consist of mortgages) and the multi-year growth in household debt as key vulnerabilities to the financial system.

Although the banking system is concentrated around four large banks, we believe that competition in the Swedish banking industry is healthy. On a negative note, Swedish banks are structurally reliant on market funding and that exposes them to swings in investor sentiment. This risk is, however, partially mitigated because (i) Sweden has its own currency and, (ii) domestic investors hold almost three quarters of the country's bonds.

STABLE FRANCHISE POSITION IN SWEDEN

Volvofinans offers financial services to private and corporate customers who purchase or lease vehicles through Volvo dealers. In addition to car financing, the bank provides credit card services to more than one million

customers. The bank's car-orientated franchise is underpinned by its widely recognised brand name and a leading market share in the car-financing segment in Sweden.

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the bank. In June 2015 the Swedish network of Volvo dealers comprised 60 dealerships and 200 sales outlets and together they employed around 8,200 staff. During the first half of 2015, Volvofinans financed around 50% of sales of new cars by Volvo dealers in Sweden and of new Volvo trucks (excluding sales through Volvo Truck Centre). Volvo's car sales have maintained a relatively stable market share in Sweden of approximately 20% over the past ten years.

The Volvofinans bank franchise has been strengthened in recent years because Volvo dealers have sold other car brands, in addition to Volvo and Renault, since 2007. In addition, the bank also offers a Volvocard which essentially is a payment and loyalty card that also can be used for non-car related purchases.

PROFITABILITY IS STABLE ALTHOUGH IT LAGS LEADING SWEDISH BANKS

Volvofinans has a track-record of stable financial performance. Income before taxes and appropriations has remained in the SEK200 million to SEK350 million range for years, including the 2008/09 financial crisis. We think this is mainly because Volvo is a household-name in Sweden and the brand consistently maintains a leading market share in Sweden. The bank's diversified product offering related to owning and using cars, as well as the credit card and truck financing products, also contributes positively to earnings stability.

However, profitability is lagging behind some other banks in Sweden, while recognizing that their business model is different compared to Volvofinans. One contributing factor to this is that the Swedish banking market is competitive. In addition, the bank is majority-owned by Volvo dealers who bear the credit risk arising from lending and, thus, receive a proportion of net interest income, resulting in a less profitable bank. We also note that the bank's return on equity ratio is pushed downwards by the bank's increasing capitalisation.

The bank's efficiency is good when measured by its cost-to-income ratio that tends to be around 50% (45% at end-September 2015).

DEPOSITS REPLACING WHOLESALE FUNDING

Volvofinans is becoming increasingly deposit funded. The bank's deposit base increased to 57% of total funding at end-June 2015, compared to 19% at year end-2011. We deem the shift towards deposit funding positive because we think that deposit funding tends to be more sticky than wholesale debt funding. An increasing proportion of deposit funding also means that the bank is less exposed to shifts in investor sentiment. The above said, Volvofinans does not offer as a wide range of financial services as larger Swedish banks and that could prompt some customers to switch their deposits away from Volvofinans. However, Volvofinans has not suffered from significant deposit outflows to-date.

Volvofinans is a small Swedish bank. We believe its debt investor base is considerably smaller compared to larger Swedish banks that issue debt in multiple currencies, in many geographies, to a diverse investor base. The lack of such a deep investor community places Volvofinans at a disadvantage to those banks if markets were to dry up. Indeed, Volvofinans issued debt with Swedish government guarantees during the previous financial crisis in 2008/09, like some other Swedish banks. The bank bought back its government guaranteed debt in 2012 and is no longer party to such guarantee schemes.

Funding risk is mitigated because the bank maintains a liquidity portfolio which is of high quality. Volvofinans can also draw on a total of SEK3.7 billion (41% of issued debt at 30 September 2015) from credit facilities with well-known institutions and owners. In addition, much of the bank's lending is car-related and has a shorter-term nature compared with banks that focus on mortgage lending, for example.

ASSET QUALITY IS GOOD ALTHOUGH THE BANK FOCUSES ON CAR FINANCING

Volvofinans's problem loans ratio is consistently below 1% and that is very low considering that the bank is almost exclusively focused on vehicle-related financing. We consider it more risky compared to, for example, mortgage lending, hence an adjustment to the asset risk ratio in the scorecard.

The bank mitigates credit risks through an agreement that obliges the car dealers to stand for losses that arise from car financing. Moreover, Volvo dealers are obliged to buy back problem loans from the bank. The bank will only take a loss after (1) the end customer suspends payments, (2) the dealership suspends payments, and (3) the market value of the vehicle is less than the residual value of the loan.

Volvofinans car-sector concentration is very high compared with sector concentration of other Swedish banks. In addition, the bank's distribution network consists of a relatively small number of dealers. Hence the bank's financial performance is correlated with the performance of the Swedish auto industry to a greater extent than

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many other Swedish banks. Although the bank's credit card business adds some diversification, card lending volumes remain below 10% of total lending (6% at end-September 2015), and is the bank's main source of loan losses because these loans are not backed by collateral.

CAPITAL POSITION IS GOOD BUT EQUITY INVESTOR BASE IS LIKELY SMALL

Volvofinans reported a 21.5% Tier 1 ratio and common equity Tier 1 ratio at 30 September 2015. That ratio has been increasing in recent years. That trend is unlikely to persist, in our view, mainly because Volvo car dealers are likely to prefer to offer loans with lower rates to customers instead of building excess capital in the bank.

The bulk of the bank's equity is located in an untaxed reserve on the balance sheet. This balance sheet entry increases as a result of accelerated depreciation that, in turn, reduces the bank's tax bill. Untaxed reserves essentially consist of profits that have not yet been taxed. In our capital calculations, we deduct taxes from the untaxed reserves and treat the net balance as equity.

Volvofinans is owned by Swedish Volvo dealers (50% stake), the AP6 Swedish state pension fund (40%) and the Volvo Cars Group (10%). Such concentrated ownership implies that Volvofinans does not benefit from a the more diverse equity investor base that some of its larger Nordic peers have. That said, we are unaware of changes to the investor base and understand that for example the AP6 funds remains committed to its holding in the bank.

NOTCHING CONSIDERATIONS

LOSS GIVEN FAILURE AND ADDITIONAL NOTCHING

We apply our advance loss-given-failure analysis on Volvofinans as the bank is subject to the EU Bank

Resolution and Recovery Directive (BRRD), which we consider to be an Operational Resolution Regime. For this analysis we assume that equity and losses stand at 3% and 8%, respectively, of tangible banking assets in a failure scenario. We also assume a 25% run-off of "junior" wholesale deposits and a 5% run-off in preferred deposits. Moreover, we assign a 25% probability to junior deposits being preferred to senior unsecured debt. These are in line with our standard assumptions.

We believe that Volvofinans's deposits are likely to face low loss-given-failure, due to the loss absorption provided by unsecured debt (should deposits be treated preferentially in a resolution). In addition, the bank has a large deposit base, meaning that any losses would be spread over a large base, thus translating into low losses for the individual depositor. The bank's long-term deposit ratings consequently receive a two-notch uplift to A3.

GOVERNMENT SUPPORT

Volvofinans's ratings do not benefit from government support.

COUNTERPARTY RISK ASSESSMENT

We assign a long-term and short-term CR assessment of A2(cr) and P-1(cr) respectively.

CR Assessments are opinions of how counterparty obligations are likely to be treated if a bank fails and are distinct from debt and deposit ratings in that they (1) consider only the risk of default rather than the likelihood of default and the expected financial loss suffered in the event of default and (2) apply to counterparty obligations and contractual commitments rather than debt or deposit instruments. The CR assessment is an opinion of the counterparty risk related to a bank's covered bonds, contractual performance obligations (servicing), derivatives (e.g., swaps), letters of credit, guarantees and liquidity facilities.

About Moody's Bank Scorecard

Our Scorecard is designed to capture, express and explain in summary form our Rating Committee's judgment. When read in conjunction with our research, a fulsome presentation of our judgment is expressed. As a result, the output of our Scorecard may materially differ from that suggested by raw data alone (though it has been calibrated to avoid the frequent need for strong divergence). The Scorecard output and the individual scores are discussed in rating committees and may be adjusted up or down to reflect conditions specific to each rated entity.

Rating Factors Volvofinans Bank AB

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Macro Factors

Weighted Macro Profile Very Strong -

Financial Profile

Factor Historic Ratio Macro

Adjusted Score

Credit Trend Assigned Score Key driver #1 Key driver #2 Solvency Asset Risk

Problem Loans / Gross Loans

0.6% aa1 ← → a3 Sector

concentration

Capital

TCE / RWA 24.6% aa1 ← → a1 Stress

capital resilience

Profitability

Net Income / Tangible Assets

0.8% baa1 ← → baa2 Expected trend

Combined Solvency Score aa2 a3

Liquidity

Funding Structure Market Funds / Tangible

Banking Assets

33.6% baa3 ← → baa3 Deposit quality

Liquid Resources

Liquid Banking Assets / Tangible Banking Assets

12.9% baa3 ← → baa3 Stock of liquid assets

Combined Liquidity Score baa3 baa3

Financial Profile baa1

Qualitative Adjustments Adjustment Business Diversification -1 Opacity and Complexity 0 Corporate Behavior 0 Total Qualitative Adjustments -1 Sovereign or Affiliate constraint Aaa Scorecard Calculated BCA range baa1 - baa3

Assigned BCA baa2 Affiliate Support notching 0

Adjusted BCA baa2

Instrument Class Loss Given Failure notching Additional notching Preliminary Rating Assessment Government Support notching Local Currency rating Foreign Currency rating Deposits 2 0 a3 0 A3 A3

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