ProCredit Holding AG & Co KGaA
XETRA:PCZ
Earnings Call Analysis
Q3-2023 Analysis
ProCredit Holding AG & Co KGaA
ProCredit Group, a banking group focusing on small to medium-sized enterprises (SMEs), exhibited robust performance in the third quarter, with management pleased about the positive margin development and strong business results. The Group's operating income increased by 22% compared to the previous year, and the cost-to-income ratio maintained at a favorable 58.7%. The Group has grown its deposit portfolio by EUR 0.5 billion in the quarter, marking a substantial increase, but loan portfolio growth was more subdued due to strategic reductions, particularly in Ukraine.
Despite a challenging global macroeconomic and political landscape, the quality of ProCredit Group's loan portfolio remained steadfast, with the share of defaulted loans declining. This resilience contributed to an impressive return on equity of 13.6% and a result of EUR 94 million for the Group, prompting an optimistic outlook adjustment for the financial year 2023. Loan portfolio growth was 1.9% year-to-date, with green loans accounting for over 20% of the total portfolio, reflecting the Group's continued momentum in environmentally friendly lending.
ProCredit's strategic focus on building a large and granular customer base has paid off with deposits growing by EUR 649 million in nine months, a year-on-year increase of almost EUR 1 billion. This resulted in an enhanced deposit-to-loan ratio of 111%, which is expected to unlock additional potential and solidify margins. The Group also boosted its CET1 ratio by 1.4 percentage points to 14.9%, reflecting improved capital adequacy and sound risk management.
Operating expenses rose by 19% primarily due to personnel, IT, and marketing investments. The focus remained on capacity building and ambitious growth, balanced by maintaining institutional resilience. The enhanced efficiency in operations resulted in a cost-income ratio of 53% for banks in Southeastern Europe, demonstrating effective cost management across the Group.
With an 11% quarter-on-quarter increase, the net interest income benefitted from high interest rates, with most loans being variably priced. Moreover, net fee income increased thanks to the expansion of payment services and focus on growing the client base, including non-loan SME clients, which enhances the Group's operational performance.
Loss allowances were higher in the third quarter, largely due to provisions in the Ukrainian portfolio. However, the Group continues to exhibit a strong portfolio quality with stable loan performance metrics. The implementation of risk-weighted asset efficiency measures contributed significantly to the Group's CET1 ratio, achieving earlier set risk reduction goals.
ProCredit maintains cautious guidance in light of regional geopolitical tensions, such as the Ukrainian conflict and its implications for neighboring countries. However, the economic outlook for the Group's operating countries has slightly improved from earlier in the year, with inflation slowing down and GDP growth expectations modestly rising. This backdrop has led to an overall resilient and optimistic attitude among ProCredit's SME clients, with preparations for potential adversity around labor shortages, immigration pressures, and uncertain energy supplies for the winter.
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Ladies and gentlemen, welcome and thank you for joining the ProCredit Holding Q3 2023 Results Conference Call. [Operator Instructions]I would like now to turn the conference over to Hubert Spechtenhauser. Please go ahead, sir.
Welcome to everybody on this call on the Q3 results for the ProCredit Group. My name is Hubert Spechtenhauser. I'm the Chairman of the Management Board. As always, I'm joined by Christian Dagrosa, our Chief Financial Officer. We aim to spend some 40 minutes to cover today's presentation, which has been available since earlier today on our website. We will, of course, give sufficient time for any questions you may have.Let me also provide you with the usual warning to pay particular attention to the cautionary statements regarding forward-looking comments that you will find at the end of the results presentation.With this, let us turn to Slide 1 and outline today's call. I will cover the highlights before Christian addresses the financial performance and major risk indicators in more detail. I will then close the presentation with some remarks on our outlook. In short, we are very satisfied with the developments in the third quarter.
Ladies and gentlemen, we have an interruption from Mr. Spechtenhauser's line. Please hold your line.
Well, sorry for that interruption. I would just start a little bit earlier than when I was probably interrupted. In short, we are very satisfied with the developments in the third quarter. Positive margin development and a good business performance have helped us achieve further quarter-on-quarter increases of our operating income and consolidate the financial results around the strong level of the half year.Our business development continues to focus around our deposit portfolio, which we managed to grow by a record half a EUR 0.5 billion in the last quarter alone. Our lending business is also going well in most of our banks, though loan portfolio growth on the group level appears more muted due to portfolio reductions in Ukraine, and a few other banks.Portfolio quality has remained steady as the share of defaulted loans decreased in Ukraine as well as in the group as a whole. Of course, the global macroeconomic and political context is challenging, but our SMEs are proving to be very resilient and are in an optimistic mindset.Beyond that, we continue to expand our client base at a very good pace and thus managed to strengthen non-loan related revenues and maintain a solid pipeline for future business growth. While interest rates are at high levels now, we are already now occupied with the task of structurally consolidating margins, placing high focus on profitable growth and building a large and granular deposit base to lower refinancing costs.With these opening remarks, let me turn to Slide 2. This highlight slide summarizes the encouraging results we achieved at this point of the year. Our group achieved a result of EUR 94 million, helping to return on equity to a strong level of 13.6%. Operating income shows an increase of 22% year-on-year, as both net interest and net fee income continues to develop very positively. The cost income ratio is at a good level of 58.7%.All our banks in Southeastern and Eastern Europe, including the bank in Ukraine, contributed positively to the results. Some of them show in part significant improvements in profitability and cost efficiency, and almost all of them account for solid 2-digit return on equity figures.As a consequence of these results and the continued positive dynamics of key indicators, we lifted our outlook for the financial year 2023 earlier in October. We will cover our outlook at a later point in this presentation.A strong development in our P&L was combined with resilient, impact-oriented development of our balance sheet. Our loan portfolio increased by 1.9% year-to-date, which includes a targeted reduction in Ukraine of around 7%. In Q3 alone, we achieved a solid growth of 1.1%, and thus continued to build momentum after the good growth of the previous quarter.Our deposit-to-loan ratio increased to 111%, as deposits continued to develop very positively across all banks. Portfolio quality has remained steady, which supports the moderate cost of risk of 20 basis points for the first 9 months.Our CET1 ratio increased by 1.4 percentage points since the beginning of the year to 14.9%. As we move forward, important risk-weighted asset sufficiency measures, 93 basis points increase in the CET1 ratio result alone from higher risk-weighted asset sufficiency. Christian will cover the details.Slide 3 shows the development in customer loans. At the group level, the portfolio increased by EUR 119 million year-to-date. That includes a reduction in Ukraine of EUR 39 million. In the first quarter, we recorded a portfolio decline of around 1%. Since then, we see investment appetite amongst our SME clients gradually returning, allowing us to achieve a solid growth over the last 2 quarters of EUR 165 million or 2.7 percentage points.Our focus remains on our core small business clients, who we think are often inadequately served by other banks and to whom our house bank proposition adds most value.Vice versa, this segment typically provides good margins and a favorable deposit reciprocity and is also less capital intensive than larger exposures. You can see on the lower half of this slide, the very good development in the green loan portfolio year-on-year to reach over 20% of our total loan portfolio. Development in green loans in the first 9 months of the year was broadly in line with the development of the portfolio as a whole.Slide 4 shows the development in deposits. Building a large and granular customer base has been a key strategic priority for us since last year, as we aim to solidify the high margins that are driving profitability today by a broader and more diversified funding structure. We also see distinct potential for positive impact in providing secure, transparent and accessible deposit services for our clients and reinvest these funds in the SME sectors of our countries.Since the beginning of the year, deposits grew by EUR 649 million. That's a strong 10.3% growth rate in only 9 months. Year-on-year, deposits have increased by almost EUR 1 billion or 15.9% at a time when market liquidity is much more constrained than in previous years. We are proud of this development and it speaks for our solid and strong positioning as an SME bank at the one hand as well as the attractiveness of ProCredit Direct in the eyes of our private individual clients.Half of the deposit growth has come from private individual clients' deposits, half from business clients. Our deposit-to-loan ratio is up 16 percentage points year-on-year, with positive developments across almost all banks. We are certain that this development will gradually unlock additional potential of our banks to scale business and solidify margins.We perceive the global macroeconomic and political environment in light of the conflict in Ukraine and the Middle East as tense. Such conflicts, though not always directly related, can spore additional tension on a regional level. A good example is the occasional flaring of hostilities at the Serbian-Kosovo border. It is because of these events that we have been cautious in guiding our results since the beginning of the year and continue to plan under the assumption of adverse conditions in the short-term horizon.The economic outlook of our countries of operation has slightly improved since the beginning of the year. Inflation has slowed down and expectations for GDP growth have slightly improved, including for Ukraine, for which economies now expect a GDP growth of 2 to 3 percentage points, so broadly in line with the region. We experience an overall robust attitude from our clients.A quick view on the challenges they have vetted in the course of the last few years, including COVID, energy shortages, trade restrictions against Russia, persistent inflation and increasing interest rates, clearly underlines their resilience and ability to adapt even to adverse conditions.Currently, shortage of qualified labor and continued pressure from immigration, as well as some uncertainty regarding energy supply and prices for this winter, though less pronounced as last year, probably rank amongst the biggest concerns amongst them. Moreover, severe floodings in Greece have impacted SMEs and renewable energy projects in the region of Thessaloniki, in which our Bulgarian bank is active. More broadly, many of our clients were encouraged by the strengthened international interest in the region.Since last year, we have seen significant increased momentum regarding EU accession and some increase in foreign direct investment. The geopolitical importance and economic potential of our countries of operation and the central role that SMEs play therein remains a driving force behind the impact and financial potential of our group.With these strategic reflections in mind, let me now hand over to Christian.
Thank you, Hubert. Let us now take a closer look at the financial performance of the group year-to-date and quarter 3 in particular, as well as the major risk and capital indicators as of September 30. As always, we report on our bank in Ukraine, which continues to show good financial results and operational resilience.Let us start by looking at the financial results line-item by line-item, starting with the operating income and expenses. Operating income has grown strongly year-on-year. We have seen this in -- the previous 2 quarters, but it is to say that the dynamics do remain overall positive. As of September, we recorded an increase of EUR 55 million, or 22%, due to improvements in all net interest, net fee and FX income. This development comes on top of the strong year-on-year increase recorded already in 2022 of 21%.Also, I should note that these are very granular improvements on the level of almost all ProCredit banks, showing that our business model works well in all our markets. Operating expenses increased by EUR 27 million, that is 19%. Of course, we will cover this in greater detail later, but the main driver remain personnel expenses, as well as IT and marketing expenses, as covered in the previous calls.All in all, our income before tax and loss allowance increased substantially by EUR 27 million, and the cost-income ratio improved by 2 percentage points to a good level of 58.7%. And it is important to note that this is on a reported level, i.e. without the adjustment of one-off items.Let us move on to net interest income. Quarter-on-quarter dynamics remain visibly positive for both net interest margin and net interest income. With respect to the previous quarter, net interest income is once again up by almost EUR 9 million or 11%, while the net interest margin expanded by an additional 26 basis points after a persistently positive development over the previous 15 months. This too is a very granular development happening on the level of most ProCredit banks.Year-on-year, net interest income is up EUR 53 million or 27% on the basis of a net interest margin for the first 9 months of 3.6%. That is 53 basis points above the previous year period. Overall, we continue to benefit from the high interest rates, also because loans are largely variably priced and investment securities are conservatively placed for rather short-term horizons.Liabilities are dominated by our fast-growing deposit base, which now exceeds the loan portfolio on the level of most of our banks. Interest expenses are, of course, also rising. We see above all private individuals seeking to place money with our banks long-term through TDAs. However, at current policy rate levels, volume and pricing-related increases in interest expenses are largely offset by income generated from placing excess liquidity at central banks and governments.Moving on to fee income, quarter 3 net fee income increased by EUR 400,000 with respect to quarter 3 2022, that's approximately 3% and broadly correlates with the expansion of our client base.Year-on-year, net fees are up EUR 3 million or 7.4%, especially thanks to the steady expansion of payment services. We continue to focus on growing our client base, including what we call non-loan SME clients, who appreciate our strong regional presence and competitive international payment services beyond our lending services. With these clients, we are able to enhance operational performance without driving risk-weighted assets, grow our deposit base and build a solid pipeline for future loan growth.Moving on to personnel and admin expenses, our cost base has grown over the last quarters because inflation has been driving prices and because we continue to invest strongly in many front office areas to further expand our positioning in our markets. Personnel expenses remained the major driver behind that trend, adding more than half to the overall cost increase.In short, we are strongly focused on building capacity across all our entities in order to grow ambitiously in the years to come, while maintaining institutional resilience. In addition, high inflation rates and tight labor markets have made it necessary to revise salaries on the level of almost all ProCredit entities. And otherwise, we continue to invest strongly in IT and marketing, especially as we aim to further position ourselves as an attractive direct retail bank in our markets. Quarter-on-quarter, personnel and administrative expenses grew by EUR 3.8 million, while the cost-to-income ratio improved to a good quarterly level of around 57%.Moving on to loss allowances. Loss allowances were at a more elevated level in quarter 3 than in previous quarters, EUR 8.5 million in total corresponding to an annualized cost of risk of 55 basis points. The larger part of this amount came from our Ukrainian portfolio, where we booked EUR 4.6 million of provisions to reflect the expected impact of termination of the grain deal on our agri-producing clients in the country.Approximately half of our agri-portfolio is now classified in stage 2. Beyond that, we have added an amount of approximately EUR 3.4 million in management overlays in quarter 3, of which a large share is to account for the continued parameter in security in Ukraine.Year-to-date, we see a total loss allowance in the amount of EUR 9 million, to which again our Ukrainian bank contributed slightly over EUR 6 million. Regular through-the-cycle stage transfers on the level of the group, marked here under credit risk, have added some EUR 15 million to the total loss allowance this year, which is moderate and has been offset to a large extent by recoveries of written-off loans in the amount of almost EUR 10 million.Additional management overlays, as mentioned, of around EUR 4.9 million this year, bring the total balance sheet amount of overlays now to EUR 44.5 million. This figure obviously includes the provisions that were booked last year related to energy security in our markets. The year-to-date cost of risk of 20 basis points is broadly in line with the level we have -- we've been averaging out on in the previous few years and just slightly below our medium-term outlook.Let's look at portfolio quality. Given the challenging geopolitical and macroeconomic framework conditions that Hubert touched upon earlier, portfolio quality has remained remarkably steady both in and outside Ukraine. As of September 30, the share of defaulted loans improved by 0.3 percentage points year-to-date on the level of the group and 0.1 percentage points on the level of the banks outside Ukraine. The share of Stage 2 loans increased since the beginning of the year by 1.5 percentage points.On the group level, this reflects transfers from Stage 1 to Stage 2 of client groups who we assess to be potentially more exposed should interest rates continue to increase. Here we have transferred an amount of approximately EUR 45 million in the first half year, an additional amount of EUR 9 million in quarter 3.In addition, and rather specific to quarter 3, Stage 2 loans in Ukraine increased by approximately EUR 47 million as a consequence of termination of the grain deal. Lastly, Stage 2 also increased due to the floodings in Greece, Hubert mentioned earlier.Moving on to capital. Our CET1 ratio stands at a good level of 14.9%, well increased by 1.4 percentage points compared to the year-end figure. CET1 capital increased above all due to the attribution of year-end profits and interim 9 months profit. Net of the dividend accrues of 1/3 of our 9 months '23 result, as we intend to propose to next year's General Assembly, a distribution of 33% of the year-end result.Risk-weighted assets dropped by EUR 32 million against the trend of a growing portfolio and balance sheet as a whole. This encouraging development is mainly driven by a variety of risk-weighted asset efficiency measures that we've been -- that have been taken in the course of the last 12 months, which have helped reduce risk-weighted assets to a level of 64%.In total, our so far executed risk-weighted asset efficiency measures contributed 93 basis points to our CET1 ratio. And we are pleased to highlight that we already executed efficiency measures reducing risk-weighted assets by approximately EUR 440 million, already reaching the EUR 0.3 billion to EUR 0.4 billion risk-weighted asset reduction goal we had indicated during our analyst workshop in March. However, we remain further committed and aim to improve our risk-weighted asset density towards around 60% in the medium term.Let's move to the segments and our usual deep dive on Ukraine. Our banks in Southeastern Europe continued to achieve very convincing results. Their contribution to the consolidated profit was a strong EUR 72 million, averaging a return on equity of 14.2%. The cost-income ratio of 53% is well below our group's medium-term target and underlines the cost-efficiency potential of our group.Our 2 Eastern European banks in Georgia and Moldova contributed close to EUR 20 million to the consolidated result, which corresponds to an average return on equity of 18.3%. South America, or our Ecuadorian bank, recorded a loss of EUR 1.4 million. I will come to this point later.And ProCredit Bank Ukraine achieved a good interim result of EUR 16.4 million, which corresponds to a strong ROE of 33%, even as the cost of risk stands at a relatively high level of 146 basis points.Let us take a deeper look into the performance of our segments and the banks therein. As I mentioned, profitability of our largest segment, southeastern Europe continues to improve, both structurally as well as in absolute terms. Higher net interest income on the back of overall stable margins helped achieve a 32% increase in operating income year-on-year. The net interest margin is at a good level of 3.3%, 70 basis points above the previous year, and the cost of risk is at a steady level of 24 basis points. On the bank level, return on equity and cost-income ratio improved or remained at strong previous year levels, with just 1 exception.In Eastern Europe, operating income is up 13%, and the cost-income ratio is at a strong level of 43%, which is 2.6 percentage points below the previous year. Our banks in Georgia and Moldova increased their result contribution by 30%, reaching an average ROE of 18%. And with Ukraine's strong profit contribution of EUR 16 million, the segment's ROE is at an even stronger level of 23%.Coming back to Ecuador, whose KPIs are shown at the bottom right corner of this slide, I already pointed out the interim loss, which has come after the bank had indeed shown some rather promising dynamics in the course of the last years. As a matter of fact, Ecuador is the only bank not benefiting from the current interest rate environment, as lending rates in the country are capped by the Ecuadorian Central Bank.Higher dollar rates, therefore, increase refinancing costs without providing any relief on the asset side, thus putting pressure on net margins. We are steering against this difficult regulatory environment by focusing our disbursements on lower volume segments with significantly higher lending caps.Let's move on to Ukraine. In terms of banking operations, there is really little new to report. Loan disbursements are constrained, continue to be constrained as we limit ourselves to existing clients outside the conflict area. At the same time, we are laying the foundation for future growth in what will hopefully soon be a new post-war era for the country.For example, we are achieving substantial growth in our deposit base, EUR 133 millionyear-to-date, that's more than 21%, bringing the deposit-to-loan ratio up by 50 percentage points to 138%. Also, ProCredit Bank Ukraine is one of the very few banks active in the local labor market, selectively hiring and training again. Total staff numbers are up 8% since the beginning of the year. Beyond that, we also invest in our front-end applications and smoothen and further automize digital client onboarding processes.In 2023, our ProCredit Ukraine's headquarter became the first office building in the country to receive EDGE certification after several modernization initiatives helped optimize energy and water usage. It may seem like a rather insignificant anecdote in the greater context of the ongoing war of aggression against the country, but we view these efforts as emblematic for the strong spirit of our colleagues and the resilience of our institution, allowing colleagues to focus on environmental issues, which are important to us as ProCredit even in the midst of a war. For those interested, we added a special slide on our building certification in the annex of this presentation.Overall, the bank is in good shape, thanks to the focused work of our colleagues on the ground. I already highlighted the bank's good profit of more than EUR 16 million, which corresponds to an ROE of 33%. The portfolio reduced only slightly in quarter 3, approximately EUR 6 million, bringing the year-to-date reduction to EUR 39 million. Overall, reduction has been significant though, with our bank in Ukraine now accounting to 8.7% of our total loan portfolio, compared to 13% mid-last year.The share of defaulted loans reduced by approximately 2 percentage points to 10.5%, as the bank continues to recover and write-off exposures, including in occupied areas. Loans in the red zone reduced by EUR 25 million since the beginning of the year, that's more than 40%, and capitalization is at a good level of more than 13%, which provides a buffer to requirements of more than 6 percentage points.Overall, we view the bank's performance as very positive and look forward to the day on which our bank can engage again more actively with Ukrainian SMEs and support the construction efforts of the country. And with this hopeful outline, let me give the word back to Hubert for a short wrap-up on guidance and some closing remarks.
Thank you, Christian. I had mentioned in my opening remarks, because of the good financial results, in particular the good diversification of positive trends across our banks, we once again raised our short-term outlook for the return on equity and the cost-income ratio earlier in October.We now expect for the year-end a return on equity on the level of our median-term guidance of around 12 percentage points, plus, minus 1 percentage point, and a cost-income ratio of 60 percentage points to 62 percentage points.We still conservatively assume in this guidance that risk costs in Q4 will be elevated due to the continued war against Ukraine and the more general risks in global markets. We have also revised our guidance for the loan portfolio growth to a low to medium single digit figure. In this year, we have been developing business rather carefully, placing a lot of focus on profitable growth and deleveraging in a controlled and targeted way from certain client groups in Ukraine.The increased focus on profitable clients has led us to even more rigorous application of the house bank concept, which has negatively affected the top-line figure in other markets. Nevertheless, we are certain that this is the right way forward to ensure long-term margin resilience.On Slide 21, you see our confident mid-term outlook. I will not dwell on it too much now, except to say that we feel confirmed in our confidence based on the good results we presented today. We are very cautious of the prevailing challenging context, but we are also confident in our long-term experience in working in our markets and in the quality of our clients.We also see plenty of potential for our countries of operation, if and as soon as the situation in Ukraine stabilizes, our bank there aims to play a valuable role in vital recovery initiatives. Equally, we look forward to supporting our SME clients to grow, formalize and contribute to sustainable regional development in our Eastern European and the West Balkan countries of operation as they accelerate their EU accession efforts. We look forward to elaborating on these points as well as new strategic initiatives in our next Capital Markets Day in March 2024.With that, let me conclude this presentation. Christian and I would now take your questions.
[Operator Instructions] Our first question comes from Milosz Papst from Edison Group.
Yes. And congrats on the strong results. First, I wanted to ask about the negative effects from liabilities repricing of EUR 53 million in the 9 months this year. I presume it does include some partial offset from a positive mixed effect, right? I mean, the increasing share of deposits in your funding mix. So are you able to quantify this in any way? So what would be the repricing effect on your liability side without the positive mixed effect?My second question is, in a scenario in which the war in Ukraine becomes a frozen conflict, do we expect a stronger earnings contribution than in your mid-term guidance, right, which is now upper single-digit to lower double-digit? I mean, when you look at the 9 months figures, the 9 months profit of EUR 16.4 million, it's quite strong and includes EUR 6 million of loss allowances, right? So, to what extent do you feel this might be sustainable or even higher, assuming lower loss allowances in case the conflict stagnates?And finally, what is your view on the resilience of your Ukrainian SME clients to power outages this winter, which will result from likely Russian air strikes on the infrastructure?
I think what we can say in terms of margin developments is indeed that there is a strong volume and pricing effect on the deposit side, which is reflected really in the increase of interest expenses, as you say, of EUR 57 million. But much of this effect is cancelled out by the fact that it creates excess liquidity, which we then place at central banks and investment securities.In average, what I can share is that the increase in the cost of customer funds, the average cost of customer funds over a 9 months period is about 70 basis points. So, it went from 1% to 1.7%. And the dynamic is still that it is slightly increasing, as is the dynamic of the average income on loans. This is the sort of the quarter-on-quarter dynamics. This was on the first question. Hubert, if you want to take the next one.
Well then let me please take the second question on Ukraine. And if I understood you correctly, you were asking whether -- how a frozen conflict in Ukraine might affect our future development in the country. Let me go back to what we have been conveying throughout the entire year, i.e., that in Ukraine, we do distinguish between different scenarios. We do assume in our medium-term guidance, a base case scenario in which Ukraine would contribute marginally to the group results, even in the medium-term in the region of a high single-digit, low double-digit million, profit contribution coming from Ukraine per year.And we always said that that would be applied under the assumption that the conflict would be contained, broadly speaking, in what is currently going on the ground. And we always also indicated that there is a downside case in case we were to lose Ukraine, where we would have a limited loss and a limited effect by now on the group. And we also said that there is an upside case in case the situation were to stabilize. And in case there were major recovery initiatives for Ukraine and that we saw for such a case an upset for the medium-term guidance in the region of 1% to 1.5 percentage points additional return on equity at the group level.If we were to assume growth rates, which we saw before the war, i.e., double-digit loan growth rates and say, return on equity in the region of 20%. Now, it's very difficult to say what exactly -- how exactly a frozen conflict like the one you alluded to would look like. But I would assume it would come closest to our baseline scenario unless it were to be frozen for a very, very long time, which then would actually make it closer to our upside scenario, because in that instance one could assume that the free part of Ukraine potentially would be benefiting from increased support from the rest in the rebuilding of the country.The second element of your question, if I understood it correctly, was do we factor in air strikes on infrastructure for Ukraine in the upcoming months? What we do consider is not specific events, which might happen in Ukraine, but what we do consider is an increased cost of risk for the fourth quarter. We saw 20 basis points up until now at the group level. The guidance which we have recently updated does still include cost of risk of up to 30 basis points.The better part of our provisions, loan loss provisions this year does actually be booked in Ukraine. And therefore, this assumption of up to 30 basis points still would cover substantially adverse developments in Ukraine in the remainder of the year. Therefore, we do not have a specific assumption for air strikes. But we do, at the group level, assume a higher cost of risk, therefore, to reflect potential negative developments, in particular, in Ukraine in quarter 4.
I have a follow-up question to my second question. Now, do I understand you correctly that in your base case scenario, which includes your mid-term guidance, the earnings contribution from Ukraine would be lower than what will be likely the contribution this year or what you've already seen after 9 months? And if so, what are the main reasons for the difference? Why do we expect a lower earnings contribution from Ukraine in the base scenario compared to what we've seen so far this year?
Well, actually, you are right. We do assume by saying a high single-digit, low double-digit million figure year-on-year, a lower contribution than what we saw this year. The background of this is that we did build very substantial loan loss provisions last year in Ukraine. And therefore did not account as much loan loss provisions this year and that we, broadly speaking, have been very successful in Ukraine this year in the measures, which Christian indicated before, i.e., we target -- we had a target reduction in our loan portfolio, but on the other side had a very substantial increase of roughly 50 percentage points in our deposit-to-loan ratio, and therefore, also structurally improved the refinancing base.So, we had this year shifts in the structure of our portfolio, #1. And #2, indeed, we had accounted last year for a high degree of loan loss provisions, and therefore, on that basis we did not have to build that much in the course of this year.
Our next question comes from Marius Fuhrberg from Warburg Research.
Also, one on the net interest and development, which -- and especially the net interest margin, which we observed to show a positive development for the past quarters. Where would you consider this to stop? I mean, we saw 3.9% in Q3, which is a great figure. Should we expect it to remain there? Or will the deposits pick up pace with regards to what you have to pay for deposits and thus the interest margin to reverse to slightly lower levels? Or is this a level which is kind of sustainable as long as the interest rate environment remains unchanged?Another question on your portfolio. How much additional agricultural portfolio is remaining in Ukraine that is affected by the terminated grain deal and that was not yet provisioned for? Or other way around, how much additional risk costs do you expect from this in Q4? And maybe more generally, speaking of those 30 basis points, how much of this comes from the additional Ukraine risk and how much from global macroeconomic concerns?And my last question would be, you mentioned your mid-term outlook, and -- but looking at 2024, and that you mentioned that demand for loans is returning. Would you consider high single-digit portfolio growth in 2024 to be a valid assumption?
I will take the first question, Hubert will allude to the other two. So indeed, the net interest income development has been strong. At EUR 89 million, clearly better than what we had expected. Interest expenses have not increased as strongly as one might have anticipated. There is an ongoing repricing dynamic on the asset side. I think loan growth started again in quarter 2. If you recall, in quarter 1, we had a reduction, so now we also have some positive volume effects since quarter 2.I think we have to remain, yes, somewhat conservative on the deposit side. The guidance factors in certain repricing effects on the deposits. We already see effects in the first 9 months, but still in the income side still outweighs these cost effects. We obviously see a lot of clients placing funds onto term deposits. I would say most of the PI client deposit growth does come through term deposits, and there will be a continued negative pricing effect on deposits for the months and quarters to come.Then -- the base rate situation remains overall dynamic. There have been increases in 2023, including from the ECB, with decisions to keep rates constant in October and November. So, the dynamic on base rates is somewhat slowing down. Most benefits are of course benefiting from this higher interest rate environment, and we do see strong financial results across the industry, with maybe just a few exceptions.The question is how long-lasting this trend will be and how well-positioned the banks are. We have also seen banks struggling with the high interest rate environment at the beginning of the year, specifically in the United States. There is, of course, a question on the rate reversal. This can be expected sometime in 2024, but it's very difficult to predict, and it is probably the event that will most likely accelerate somewhat a margin reduction on our books, if it materializes. For us, it's of course an additional dimension, because we are a differentiated franchise, where the development ultimately depends on the development of 12 different markets.So, now to your question whether the development will continue to be positive or not. I think it's difficult to predict. Certainly, not at the current pace. In the short term, deposit rates are increasing. This continues to be visible. And pricing effects on the asset side, they will fade out, since the base rates are no longer increasing, especially on the U.S. dollar and the Euro side. And in our Eastern European segment, for example in Georgia and in Moldova, but also in Ukraine, we have already seen base rates coming down, basically since the second quarter. And in these banks, particularly in Moldova and Georgia, the quarter-on-quarter development of net interest income is already slowing down. In the case of Moldova, it's even negative.So, I know it's a non-answer, because it has a lot to do with policy rates and base rates. In short, I would say net interest income and margin development will not continue at the pace that we have seen in this year in the short term. It will not certainly revert to negative from 1 quarter to another. And base rate development will be the main determinant and the main driver of this development. Maybe, Hubert, on the second question.
Well, let me come back to your second question on Ukraine and risk considerations in Ukraine. Specifically to your question about the agri-portfolio, we deliberately shifted 50% of all of our agri-portfolio in Ukraine to Stage 2 to reflect the potential effects of the suspension of the Grain Deal. Ultimately, whether that will be the right assumption or not, we will have to see, because it very much depends on how long the Grain Deal will be interrupted. There are obviously different scenarios possible, depending on how long the suspension will be and what potential mitigation measures regarding alternative export routes there are. And we are currently in the process to assess these potential effects on a client-by-client basis. Because, as I said, now we have shifted half of the portfolio in Stage 2, but ultimately it very much depends, #1, on how long the suspension will last, and secondly, how individual clients will be affected and what alternatives they have. And we are trying to find that out in the remainder of the year.Another element of your question was how much of our assumption regarding other risk in the fourth quarter is related to Ukraine-related risk versus, more broadly speaking, macroeconomic risk. As I said, I think I hope I said it, it is predominantly to reflect the very specific situation in Ukraine, and that's also because we say up to, because it's difficult to assess, but that's the biggest risk we see in this context, less so for the macroeconomic risk.On the guidance for the next year, we have a medium-term guidance for this medium-to-high single-digit percentage growth for the growth of the loan portfolio. I would be cautious for next year, but I would assume that we will be somewhere between the growth that we saw this year. You saw that in the first quarter we had a slight decline of the loan portfolio by roughly 1%, and saw a picking up growth in the second and the third quarter. In the third quarter alone we had a 1.1% growth, and I would assume this positive dynamic also to continue in the fourth quarter and with all likelihood in 2024. Whatever that then exactly means in growth rate for the loan portfolio, in the medium term we hope that, or we expect, that we will get closer to the target of this medium-to-single-high-digit growth rate. Does that answer your question?
Yes, that's as precise as can be.
Our last question comes from Philipp Hassler from Pareto Securities.
Philip Hassler from Pareto Securities. I have 2 questions left. Firstly, on the cost development, which went up quite significantly for the first 9 months, mainly driven by the personal expenses, as you explained to us. Could you perhaps give us an outlook for next year? What can we expect? I mean, are inflation rates also coming down in Eastern Europe and Southern Eastern Europe? So, i.e., do you expect costs to increase at a lower pace next year? That's my first question.And secondly, is on your dividend policy Core Tier 1 ratio, developed very strongly so far this year, and I don't see any reason why, I mean, it shouldn't continue, or it doesn't have to necessarily continue like this, but at least at around 15% you are very well capitalized. You have this dividend policy of paying out 1/3 of your profits. Do you think about maybe rising this or making it maybe a little bit more flexible, introducing kind of a special dividend or something like this, like other companies do this, because I think you are very well capitalized, so you could easily afford to pay out a higher dividend, particularly, as you just said, that you don't expect such strong loan growth for next year?
Yes, on the cost side, I think you are absolutely right, that the increase has been substantial in this year in particular. The drivers are known. It's high inflation in our countries, typically 2-digits in each of our countries of operation, and the other driver are really significant investments that we have been undertaking in marketing, in IT. What we observe now is that inflation is indeed slowing down. In most of our markets, it is now at a medium single digit figure, which is, I would say, absorbable, and probably what one should expect in the short term, sort of a more normalized inflationary environment, not a zero inflation or negative inflation environment as in, let's say, the years running up to 2022.So inflation will continue to drive costs, but not nearly as strongly as in this year. What will continue to drive costs on our side is certainly personnel expenses. We do continue to increase capacity, and it is clearly with the intention of driving business into the future, sort of really a long-term investment of creating the necessary capacities today in order to grow more ambitiously in the future. And the other investments do include, as I said, marketing, which is up approximately EUR 2.5 million year-on-year, actually EUR 3 million year-on-year, as well as IT as we do continue to invest, especially in front-end applications.We do want to be a market leader in front-end applications. That means distinguish ourselves as one of the most client-centric and technologically affine and friendly banks in the market in order to position ourselves as an attractive bank for PI. This has been at the core of our strategy in the last 2 years. We continue to build on this, and we think that these investments, they will generate the return in the form of future fee income, in the form of a more granular funding base that will help us consolidate margins at the currently good levels. Hubert, if you want to take the second question.
Yes, Mr. Hassler, if I may, I would take your second question about the dividend policy and the solid CET1 ratio. We have been communicating in the course of this year always that we intend, if nothing very spectacular were to happen, to return to our dividend policy, i.e. to pay out 1/3 of group profit in the course of next year, i.e. to propose that to the AGM next year in June. We do think that paying a dividend in that magnitude is important for our credibility in the capital markets, and therefore we try to be very consistent on that, and indeed paying out 1/3 of our profit for the fiscal year 2023 at current share price levels should in itself provide a very, very attractive dividend yield.Therefore, we do see our dividend policy of, as I said, 1/3 of group profit as our primary measure, and for the time being, we do not plan for any additional measures. We would not rule out that for the future, but for the time being, our intention is to go back to our dividend policy and to pay out 1/3 of group profit in the course of next year.
Ladies and gentlemen, thank you for your participation. I hand back to Hubert Spechtenhauser for closing comments.
Thank you all for your interest and your participation in our analyst call covering our quarter 3 2023 financial year results. We hope to have given you as much transparency as possible. If you have any additional questions, please do not hesitate to contact Christian or Nadine.The next scheduled conference call will take place when we publish our results for the financial year 2023 on March 20, 2024. Thank you once again for your participation. Thanks.
Ladies and gentlemen, the conference is now concluded and you may disconnect your telephone. Thank you for joining and have a pleasant day. Goodbye.