Ratings On Finnish Municipality Finance And Municipal Guarantee Board Affirmed At 'AA+/A-1+'; Outlook Stable

  • In our view, the liquidity position of Finnish local government funding agencies Municipality Finance PLC (MuniFin) and Municipal Guarantee Board (MGB) will remain strong. Policy refinements and active asset liability management are set to strengthen the agencies' liquidity positions and they will maintain comprehensive access to the central banking system despite recent changes to the European Central Bank's collateral policy.
  • The ratings on MuniFin and MGB continue to be supported by a strong market position, highly creditworthy borrowers, and a very strong risk-adjusted capital position.
  • We continue to assess MuniFin and MGB as core entities in the joint Finnish public-sector funding system.
  • We are therefore affirming our long- and short-term 'AA+/A-1+' issuer credit ratings on MuniFin and MGB.
  • The stable outlook reflects our expectation that the structure of Finland's municipal funding system will remain unchanged, that MuniFin will remain the sole recipient of MGB's guarantees, and that local government sector reform is unlikely to weaken the group's public policy mandate materially in the next two years.
STOCKHOLM (S&P Global Ratings) Jan. 11, 2019--S&P Global Ratings said today 
that it affirmed its 'AA+' long-term and 'A-1+' short-term issuer credit 
ratings on Finnish local government funding agencies Municipality Finance PLC 
(MuniFin) and Municipal Guarantee Board (MGB). The outlooks are stable. 

At the same time, we affirmed our long-term issue rating on MuniFin's 
subordinated debt at 'A-'. 

The affirmation reflects our view that policy refinements and active asset 
liability management are set to sustain MuniFin's and MGB's strong liquidity 
position and that they will maintain comprehensive access to the central 
banking system despite recent changes to the European Central Bank's (ECB's) 
collateral policy.

MuniFin and MGB comprise the funding system for Finnish local and regional 
governments (LRGs). Given the institutionalized links and close integration 
between these two entities, we consider them to be a de facto group, and we 
assess the group credit profile (GCP) at 'aa+'. MuniFin's lending and funding 
activities dominate the group's operations; hence our assessment of the 
group's enterprise risk relies mainly on MuniFin's credit features. Our view 
of the financial risk profile stems from our analysis of the combined entity.

We believe the group has a very strong enterprise risk profile and a strong 
financial profile. These assessments reflect our view of the group's strong 
market position, supported by highly creditworthy borrowers. In addition, the 
group has excellent risk-adjusted capitalization and strong liquidity, 
complemented by comprehensive central bank access, which alleviates our 
concerns about a recurring structural funding gap. 

Moreover, we see an extremely high likelihood of the group receiving 
extraordinary financial support from its local government shareholders via 
MGB, should it experience financial stress. This lifts the GCP to 'aa+'. 

We consider MuniFin to be core to the group, since MuniFin conducts all 
lending and funding activities and plays a key role in the joint municipal 
funding system for Finland's local governments. Its chief function is to 
provide efficient funding to the Finnish municipal sector and the social 
housing sector, guaranteed by the government of Finland. MuniFin has close 
links with the LRG sector, as well as with central government, as shown by its 
lending mandate and the statutes that govern it. 

We also consider MGB to be core to the group, and a crucial component of 
Finland's joint municipal funding system for LRGs. The LRG sector's guarantees 
of the group's financial liabilities are all provided through MGB. 

In our review, we have also affirmed our assessment of MuniFin's stand-alone 
credit profile (SACP) at 'aa'. We have affirmed our issue rating on the junior 
subordinated debt at 'A-', which continues to stand four notches below 
MuniFin's SACP. We observe that the first call date of this additional Tier 1 
(AT1) instrument is in April 2022, which indicates a residual life of less 
than four years, resulting in minimal rather than intermediate equity content 
in MuniFin's AT1 instrument.

Enterprise risk profile: Competent execution of policy mandate, and low-risk 
lending activities 
  • A very strong public industry country risk assessment (PICRA), thanks to Finland's wealthy economy and well-developed financial sector, and the government guarantees on the group's public housing lending.
  • Proactive, competent, and risk-averse management, which assures compliance with regulatory requirements and continued execution of the public policy mandate.
  • Upcoming reform of the social and health care sector that could increase the credit risk from municipalities, alter the group's market position, and impede loan growth.
The group's operations are dominated by MuniFin's activities; hence our 
enterprise risk profile analysis focuses on MuniFin. MuniFin's mission is to 
ensure reliable and cost-efficient funding to Finnish local governments, 
municipal companies, and state-guaranteed housing entities. We estimate that 
MuniFin's lending accounts for about 60% of its eligible market. However, we 
observe increased competition, for example, from multilateral lending 
institutions offering attractive pricing. However, those entities mainly 
target certain large municipalities and their sizable projects, so we do not 
think their activities will threaten MuniFin's strong market position and 
public policy role. 

In the first half of 2018, MuniFin's lending increased by about 1.4% to €21.5 
billion, compared with 1.5% growth in 2017. The subdued increase in net 
lending is primarily attributable to the municipalities' stronger financial 
results, as municipal finances continue to benefit from the strong growth 
momentum in the national economy, which has reduced their need for debt 
financing. Other factors are the pronounced competition for financing, and 
uncertainties surrounding the upcoming social and health care reform, which 
have led local governments to postpone investments in this area. 

We view MuniFin's overall risk and financial management, and by extension, 
that of the group's, as very strong. Prudent internal risk management policies 
are enhanced by ECB supervision and bank regulation, and MuniFin is proactive 
in managing its regulatory requirements. In this regard, we observe that 
MuniFin issued an AT1 instrument in 2015 to address the potential impact of 
the proposed leverage ratio requirement. We consider it important that this 
instrument does not allow for conversion into equity.  

The regulatory authorities are yet to take a firm decision on the leverage 
ratio requirement for promotional banks such as MuniFin. However, in mid-2018, 
MuniFin's leverage ratio stood at 3.97%, suggesting that it has buffers to 
comply with the upcoming regulation. We observe that the supervisory and 
resolution authorities are yet to take a decision on the requirements for 
resolution plans and the minimum requirement for own funds and eligible 
liabilities (MREL) for promotional banks. Therefore, we cannot exclude the 
possibility that MuniFin could be required to issue Tier 3 instruments to 
comply with the MREL. We note that the statutes governing MuniFin allow only 
public bodies to be stakeholders, suggesting that hybrid instruments will not 
under any circumstance dilute the agency's public ownership base.

The Finnish LRG sector exhibits key structural features that support a high 
credit standing, such as the wealthy economy, advanced financial system, and 
strong links between the LRG sector and the sovereign. About 45% of MuniFin's 
loans are to social housing entities, and carry central government deficiency 
guarantees. We take this into account in our PICRA on Finland. 

Financial risk profile: Very strong capitalization and strong liquidity, 
boosted by comprehensive access to the European central banking system 
  • Very strong capital ratios on the back of capital strengthening in recent years.
  • Conservative liquidity policies and active central bank access that underscores strong liquidity.
  • A structural funding gap from existing levels of callable structured funding and long-term assets.
The group has a very strong capital position, with the majority of capital on 
MuniFin's balance sheet. MuniFin has an impressive Tier 1 capital ratio of 
83.2%. This is largely due to the zero risk weight applied to its loans, but 
also to strong levels of retained earnings. We assess the residual life of 
MuniFin's €350 million AT1 instrument as less than four years. We consider 
that it has limited equity content according to our methodology, and exclude 
it from our total adjusted capital (TAC) measure. As we perform the analysis 
on a group basis, we include the equity of MGB in our TAC computation. That 
said, the added equity of MGB has little effect due to the dominance within 
the group of MuniFin's financial operations. 

Our risk-adjusted capital (RAC) ratio for the group was a very strong 39.2% on 
June 30, 2018, before adjustments. After our adjustments, in particular for 
single-name concentration, the group's RAC ratio is still a very strong 24.5%. 
We expect it will stay comfortably above our 15% threshold, thereby remaining 
a key support to the group's financial risk profile.

We consider the group to have a strong liquidity position. Although MuniFin is 
exposed to risk through its dependence on wholesale market funding, we 
consider that this is mitigated by prudent liquidity policies, significant 
levels of high-quality prefunding, and comprehensive access to financing from 
the Finnish central bank. 

We continue to assess MuniFin's status as a central bank counterparty and its 
access to liquidity from the central banking system as a distinguishing 
strength. This is in spite of the recent amendment to the eligibility 
guidelines from the ECB, which disqualified a notable part of MuniFin's 
eligible municipal lending assets from being collateral. Even so, we consider 
the remaining amount meaningful and believe that the actions that MuniFin has 
taken will help to restore its level of lending asset collateral over the 
short term. 

We observe that MuniFin conducts active asset and liability management. The 
size of its balance sheet and strategies to optimize its financial position 
result in occasional volatility in its liquid assets. In our computation of 
liquid asset data as of June 30, 2018, we include contracted bond inflows of 
$1 billion that was paid out on July 5, 2018. Our liquidity sources-to-uses 
ratio indicates that MuniFin will be able to meet its financial obligations 
over a one-year period, factoring in stressed market conditions. We believe 
that recent internal policy changes will sustain MuniFin's liquidity such that 
it can cover commitments over the next 12 months, and taking into account 
stressed market conditions. 

In addition to the vast majority of its securities portfolio, parts of 
MuniFin's municipal loan book are eligible as collateral for repurchase 
agreement transactions with the central bank.

MuniFin has established debt programs and is a regular benchmark issuer, with 
a well-diversified funding profile in terms of markets, currencies, 
geographies, maturities, and investor types. Since 2016, MuniFin has also been 
issuing green bonds, which has further expanded its investor base. The Finnish 
Financial Supervisory Authority regards bonds issued by MuniFin as 
high-quality Level 1 liquid assets. 

Although MuniFin issues mainly standard funding instruments, we note that 
callable structured funding represents about 20% of its funding mix, which is 
higher than for its Nordic peers. Specifically, a majority of its structured 
funding instruments hold call options that are typically callable at three 
months' notice under certain circumstances and that we believe add potential 
refinancing risks. 

That said, the structured funding component has decreased in recent years, and 
is hedged. We view MuniFin's management of its structured funding portfolio as 
prudent and the agency accepts no market risks. All MuniFin's derivative 
contracts include stipulations for a two-way credit support annex, and the 
agency prudently accounts for collateral flows in its regular funding 
activities. 

Nevertheless, the use of structured products implies some risk to the overall 
funding profile, with early redemptions of callable funding adding to planned 
funding needs. We see a structural funding gap for MuniFin and therefore for 
the group, with our one-year assets-to-liabilities ratio at 0.80x, and a 
persistent funding gap for up to two years. The funding gap is largely due to 
the very long average tenor of lending, the majority of which matures after 
two years, combined with a recurring proportion of funding containing callable 
features. The risks are partly mitigated by the generally long-dated nature of 
the funding, which provides some headroom for adjusting the structural 
mismatch. We observe, however, that the group's funding ratio has improved 
over the past six months and we believe it has the potential to improve 
further as adopted policy changes are set to lead to a lengthening of funding 
tenures and an increased focus on public trades.

Likelihood of extraordinary support: Extremely high, via a joint and pro rata 
sector guarantee mechanism 
  • Under the joint guarantee scheme that operates through MGB, we expect that potential supporting members, with creditworthiness similar to the sovereign's, have a strong incentive to provide timely extraordinary support to the group if needed.
  • Our view of an extremely high likelihood of extraordinary support from the main supporting entities stems from our assessment of the group's integral link with and very important role for the local government sector.
The group enjoys municipal sector support through a joint and pro rata 
guarantee commitment from the LRG sector through MGB. The guarantee rests on 
an extensive and permanent membership base and the members are bound by a 
joint pro rata liability mechanism. MGB was set up by law, which ensures its 
long-term existence, and its sole purpose is to guarantee all the funding 
provided to the municipal sector and affiliates. Since the inception of the 
joint funding system for Finnish municipalities, MuniFin has been the only 
entity to meet the criteria set out in the Act on MGB, and we do not expect 
this will change in the near future. 

We assess the guarantee as predictable and immediately enforceable by law. The 
legal enforceability of the guarantee underpins our assessment of an integral 
link between the group and its municipal stakeholders. At the same time, we 
consider that MuniFin has a very important role in providing cost-efficient 
funding to the sector. 

Although the main group of supporting members is ultimately liable for only a 
proportion of the group's liabilities, the initial claims on the guarantees 
are unlimited. We therefore believe there is a very strong incentive for these 
supporting members to provide extraordinary support to the group if it is in 
financial stress, and before the guarantees are called, thereby preventing a 
default. 

The stable outlook reflects our expectation that the structure of Finland's 
municipal funding system will remain in its current form, including the 
guarantee mechanism, meaning that MuniFin will remain the sole recipient of 
MGB's guarantees. In addition, we expect that the coming reform of the 
municipal sector is unlikely to materially alter our view of the group's 
public policy mandate or our assessment of the risk from its customer base in 
the next two years. In addition, we expect that MuniFin's management will 
manage to control the risks associated with the agency's wholesale funding, 
keep its structural funding gap in check, and sustain strong liquidity.

We could lower the ratings if the municipal funding system unwinds and the 
credit quality of the underlying municipal stakeholders deteriorates, with 
credit risk from local government and state-subsidized social housing sector 
borrowers increasing significantly. We could also lower the ratings if 
MuniFin's business position weakened, for example, due to a reorganization of 
the Finnish LRG sector, or a reduced ability to execute its public policy 
mandate efficiently through the economic cycle. Moreover, downward rating 
pressure could build if the group's funding gap persists or liquidity position 
weakens.

We could raise the ratings if the underlying credit quality of the Finnish 
LRGs supporting the group were to improve, alongside that of the sovereign.