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Edited Transcript of ARL.DE earnings conference call or presentation 12-Nov-19 10:00am GMT

Q3 2019 Aareal Bank AG Earnings Call

Wiesbaden Dec 2, 2019 (Thomson StreetEvents) -- Edited Transcript of Aareal Bank AG earnings conference call or presentation Tuesday, November 12, 2019 at 10:00:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Hermann Josef Merkens

Aareal Bank AG - Chairman of the Management Board

* Jürgen Junginger

Aareal Bank AG - MD IR

* Marc Oliver Hess

Aareal Bank AG - CFO & Member of the Management Board

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Conference Call Participants

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* Benjamin Goy

Deutsche Bank AG, Research Division - Research Analyst

* Britta Schmidt

Autonomous Research LLP - Non-Designated Member

* Johannes Thormann

HSBC, Research Division - Global Head of Exchanges and Analyst

* Nicholas Herman

Citigroup Inc, Research Division - Assistant VP and Analyst

* Tobias Lukesch

Kepler Cheuvreux, Research Division - Equity Research Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by. My name is Emma, your Chorus Call operator. Welcome and thanks for joining the Aareal Bank Ag Q3 2019 Analyst Conference Call. (Operator Instructions)

And I would now like to turn the conference over to Jürgen Junginger, Managing Director and Head of IR. Please go ahead, sir.

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Jürgen Junginger, Aareal Bank AG - MD IR [2]

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Welcome, everyone, also from my side. And to keep it really short, and let's start directly, I would like to hand over to our CEO, Hermann Merkens, who is joined by our CFO, Marc Hess, and they will share the presentation and later answer your questions. Thank you.

Hermann, please?

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Hermann Josef Merkens, Aareal Bank AG - Chairman of the Management Board [3]

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Yes, good morning from my end as well. Thank you, Jürgen, for the short introduction.

So if I may start with the presentation on Page 2, which -- sorry, 3, which is a kind of summary. I would say that a solid Q3 result in a challenging environment, and let me allow to go a little bit more into the details of the environment.

First of all, clearly, we characterize that as a triangle between long-lasting political uncertainties, weaker economic outlook, economic transformational effects. And what we clearly see is more and more countries are moving into that area, which is clearly, in my personal view but I think you share that, overall challenging economic environment.

Credit liquidity in our markets is still strong, although some markets are somewhat in an on-and-off mode, meaning if a country is moving in that direction and you have to add the one or other thing that could clearly [need be] it by property type, be it for the entire country, into an on-and-off mode from commercial real estate investors, which clearly leads to effects on pricing of properties, et cetera, et cetera.

And last but not least, regulatory changes. I think we've stressed that during all the calls, but just to repeat it, all they which hoped that with Basel IV, the things will stop, I -- my personal reading of the ongoing regulatory moves is the next decade of regulatory changes is still ahead of us, although we've indexed for now 11 years. So from my end, no signs that we see a stopping of that theme.

Next point, solid, as I pointed out, quarterly results despite that environment, and we will comment clearly a little bit more in detail. And second, a strong capital position also reflecting some effects where Marc will elaborate a little bit on -- and despite a [temporarily] higher portfolio.

In the RSF business, strong new business. Year-to-date margin, above target. On the other hand, as I announced during our preliminary full year results and Marc stressed that during the Q2 call as well, the accelerated derisking initiative is started. Clearly, the results out of that are not in our original guidance, and we are successful to pick some loans which we think would [fit] to that and the measurements are economically meaningful.

Consulting/Services. I would say, the hedge to our commercial real estate business is quite well on track. The composition of deposits are optimized according to Aareal 2020 strategic program. I will dig into that a little bit in a second.

Aareon sales revenues, the growth is continuously significant. And we've invested the first EUR 1 million in the extended growth program.

Last but not least, we do -- had been awarded a Prime Status rating from the sustainability rating agency, which is more and more important to have, and clearly proud to be awarded with this Prime Status rating.

So I'm now moving into Page 5, which is dealing with the RSF business. I think I highlighted a little bit where we are here, but a little bit more on -- detail here on that page. The average year-to-date margin of 194 basis points in the first 9 months is clearly above our target, and we are optimistic to outperform the full year target of 180 to 190 basis points, so slightly above. Although in the second -- or sorry, in the third quarter, we are somewhat below. Reasoning for that is very simple. We've done 2 landmark deals in Paris, overall volume, EUR 850 million, which are about to be syndicated, part of it in Q4, part of it in Q1. But that is the main reason why the Q3 margin is a little bit below average. And as I pointed out and said, the overall full year range is expected to be above our original guideline.

Full year new business. We are now in the third, maybe Q4. It's clearly on -- expected to be on the upper range of the guidance. And as you may have seen, the short-term increase of our portfolio to EUR 28 billion. Towards the end, I would expect a level of somewhat EUR 27 billion. Maybe a little bit above, maybe a little bit below, it's totally depending on the execution.

Syndication portfolio is still on a EUR 6 billion level, which is good, and I would expect to see that portfolio at that level on year-end.

And maybe a little bit on transaction volumes. So the overall worldwide transaction volumes are down, which is clearly an indication. And I would think, in the upcoming years, we will see a reflection in new business here, so more maybe prolongations and less new, new business, but remains to be seen, clearly.

The overall transaction volume is down in all the respective markets we are active in. Somewhat better in the U.S. Interestingly enough, the cross-border deals in Europe picked up, whereas the cross-border deals in the U.S. declined heavily. So we see more institutional investors in the U.S. and more cross-border deals in Europe. Although, clearly, it has to be expected that Chinese inflow of money, clearly, it's been trending down compared to the previous year.

And having said this, which is clearly underpinning the margin pressure is the look into the overall credit liquidity, that is still strong, which indicates that the margin pressure to a certain extent will continue as seen throughout the next couple of years.

On Page 6, so to speak, a short summary of what I have already said, and mainly 2 additional aspects. NPL reduction, we are now down to EUR 1.5 billion, roughly. And as announced, the derisking initiative started. We've spent some EUR 30 million so far on that. Although having spent that, we have here the -- as of today, within our target for the full year with respect to operating income. And more important, the NII in respect of the negative interest rate environment, the divesting activities around -- which are clearly going hand-in-hand with derisking, it's still on a decent level with EUR 134 million.

If I now move to the Consulting/Services, our strong segment pillar, which is reflecting our deposits associated with funding base and the Aareon growth, which is an important part of our strategy.

In the figures, you see that the Q3 sales are up by 7%, even more on the digital end [and] was plus 21% in the first 9 months. They are showing quite strong figures. And as I pointed out, we invested the first EUR 1 million in the extended growth program, which we kind of introduced in May. So start of the May, now the first EUR 1 million has been -- and to be expected, but we are doing more here throughout the next couple of years.

On Page H -- 8, sorry, so the overall summary for the Consulting/Services segment. If I may start with the deposits business and maybe the first topic is a very important one because we already achieved the next milestone of our Aareal 2020 program with respect to deposits, meaning deposit volume. You see -- you've seen throughout the last couple of years that we are constantly somewhat on the EUR 10 billion level, but more important, we improved the composition of the deposit throughout the last couple of years, which is very, very important, and that will allow us to reflect the composition in our internal pricing model and in the calculation of use of deposit base that will be adjusted for the full year 2020 onwards. And hence, you should expect substantial effects in the second and third quarter in -- out of that. Clearly, the one effect is a simple pricing effect, but more important, the next one, the deposit base, that is the real NII contribution effect. It's not just the pricing, it's real NII contribution effect.

With respect to Aareon, we -- or sorry, with respect to the payment services, we successfully entered into a new market, Austria, and the first transaction banking customers' tenant deposits have been achieved. So that's a quite important milestone here as well.

With respect to Aareon, clearly, positive development, integral part of the Aareal Bank Group. It's a key growth driver for the Group, and we announced that in 2016, this excellent growth [prospective] [was] indicated, announced and made transparent in May 2019. Both Aareal and Aareon benefit clearly from the high customer overlap, especially in Germany. It's not just the banking business [but] simply, we are approaching the customers and "funnel" their needs into the various buckets.

As I pointed out, a strong 9-months' growth, in line with our midterm target of some 8%, 5% ERP business, 21% digital business. So very solid here. We do have further topics on the Aareon. And we increased our customer penetration on the CRM area. We launched a new product, so called Aareon Smart, platform, which are clearly front-end services. We successfully entered into new markets, Switzerland and Austria, more to be seen here in the upcoming future. And ERP system is going to live with large property managers. So all that is indicating that we are working on the ERP base but on the front end as well. So -- and hence, we think that the Aareon is in a good mode to lift off and leave the runway that they are placed at that point in time way behind.

So Marc, I think, now we -- it's your turn to go a little bit more in detail with respect to the numbers.

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Marc Oliver Hess, Aareal Bank AG - CFO & Member of the Management Board [4]

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Yes. Thank you, Hermann, and welcome from my side, too. I think you touched on [main] things and I'm happy to add some more details to the numbers now.

Starting on page 10. As you can see here and just mentioned, we achieved a solid result with EUR 64 million operating profit in the third quarter. And the same is true if we are looking on 9-months basis. Here, we had EUR 186 million after EUR 198 million in the previous year's 9 months. However, the difference is easily explained by the DHB integration costs and the [first] costs for the extended growth program of Aareon.

When we are looking into the P&L line, so just briefly here, NII, Hermann Merkens just mentioned it, it [hasn't] kept stable, but we were able to keep it stable despite of the dilution that we have to face as other banks won from the lower-for-longer scenario, but here secondly also from the derisking efforts that we have already completed, especially in the Treasury portfolio, which for the total year is calculated with roughly EUR 10 million. So this is what we are digesting, and you can see a very stable development here over the last quarters.

In derecognition income, despite of the ordinary contribution from the loan side, we also see a support here. In that case, a support from the derisking measures with plus EUR 10 million. So some improvements from the readjustment of our treasury portfolio.

When it comes to the loan loss allowances, we are, on an underlying basis, stable and have digested some EUR 20 million in the third quarter from our accelerated derisking efforts. And as just mentioned by Hermann Merkens, fee income is continuously growing. And of course, here Aareon remains the growth driver.

Looking into NII in more detail on page 11, and as just mentioned, it has been stable over 4 quarters. On a 9 months basis, despite of the development I've just described, we were even able to increase it by 1%, meaning that our good new business and, of course, the good margin development really helped here to overcompensate for the negative effects.

Derecognition results, as just mentioned, benefited from the adjustment of our Treasury portfolio. What we have done here within our derisking efforts, we have reduced especially our BBB positions here quite significantly, and this itself was driven by the reduction of our Italian government bond, which we reduced by 40%. So that also put us in the position to decrease some natural hedges on the other side, and this finally led to a positive contribution of EUR 10 million in the third quarter, which helped us to balance somehow the LLP effects from our accelerated derisking initiative.

Coming to loan loss provisions on the next slide, we can say that we had a good underlying development. There were no new NPLs in the third quarter. And as we promised during -- or throughout the year, we would like to decrease the NPLs meaningfully below last year's 2018, levels. Here, we have already made a first step, and this will be continued in the fourth quarter within our original LLP guidance.

At the same time, however, we want to use the still favorable conditions to further derisk. This accelerated derisking initiative has started. We also want to comply here with the upcoming regulation. You know that with the [prudential] provisioning, it becomes more and more expensive from an equity point of view to hold NPLs for a longer time in development. So this is something we want to reflect and just, as I mentioned, also reduce the favorable conditions that we currently face.

So what is our definition of this accelerated de risking? You can find that on page 12. We will focus -- or we are focusing on the Italian portfolio. We are looking at selected individual NPLs, so it's not about releasing big portfolios here at high discounts. We are really working at the selective level and only do deals here if, from an economic point of view, it makes sense for us.

We are somehow moving away from collateral collection. The strategy is that we did successfully over the last couple of years. As I just said, this is a reflection of the changed regulation where this doesn't make sense anymore. On top, as you're all aware, we're not writing any new development loans, which, from our point of view, also would not be in favor of this new regulation.

We also face or look at single borrowers, if we have some risk there and if we could reduce that. So this is certainly something to come. And what we have already completed outside, let's say, the NPLs or the loan portfolio is the already mentioned reduction of the Italian government bond portfolio.

All in all, regarding loan loss provisions, we had to digest EUR 30 million in the first 9 months from this accelerated derisking, EUR 20 million in the third quarter, but we were able to do so within our original guidance, as Hermann Merkens just pointed out. On that basis, let's say, just mathematically, we have adjusted our LLP guidance from -- by EUR 30 million to EUR 80 million to EUR 110 million accordingly. And as also mentioned already in the second quarter, we will further assess every opportunity that may potentially make sense, and then take a decision whether we go forward or not.

Net commission income on the next slide. As said, we have a continuously rising trend. Of course, Q3 as it is summer break, is generally seasonally weaker. Nevertheless, the trend is, I think, convincing. The fee income remains -- the Aareon remains the strong growth driver of this P&L line, and this is clearly a differentiating factor from other banks. So as you know, we want to keep the pace. This is why we presented the Aareon extended growth program in the Investor Day in May, and as promised at that time, we launched it now in the third quarter, and we will continuously execute it.

Admin expenses. Nothing really to stress here. As you can see here, a basically flat development compared to the second quarter 2019, so no surprises. As you all know and as we communicated previously, we are up compared to last year, but this is only driven by base effects. One is DHB integration; then, of course, the acquisition of plusForta; and the growth of Aareon, which at the cost-to-income ratio of 80% is, of course, reflected in the admin expenses. And on top, we had in total over the last 9 months, EUR 7 million less reversal of provisions. So if you can see that, we are, at least, flat underlying.

Looking at capital on Page 16, regulatory capital ratios. We are, as you all know, in a very solid position here. We have already digested the TRIM effect and the prudential provisioning. Here, we have, of course, added additional reserves in the third quarter [through] this prudential provisioning requirements. The ratios, as you can see it here, Basel III are at 17.1%, Basel IV at 12.6%. So they have been somehow diluted compared to the second quarter, one, from the temporarily higher commercial real estate finance portfolio, which is clearly now at the upper end and where Hermann Merkens just indicated that it will trend back to the mean as we target for Q4. Second, from the loan [for prolonger] environment here, and I think other banks have talked about that, too. We had to digest the lower rate effect in the discounting of our pension provisions. Just as a reference, in Basel III, that costed us 50 basis points throughout 2019, even 20 basis points here only in Q3 isolated.

On top, and this is certainly interesting because this is something many banks have been warning about, Basel IV, we experienced the differences between Basel III and Basel IV here quite interestingly in the third quarter. So that, is always criticized, the floor and the minimum RWA weighting is disadvantageous for our high-quality exposures. This is what we have seen here. Whilst we have seen a qualitative improvement in our portfolio that brought the RWAs under Basel III even down by EUR 150 million quarter-on-quarter despite of the volume increase, the Basel IV numbers show different pictures. Here, RWAs increased even by EUR 500 million driven by the temporarily higher volume as the good ratings are floored and, therefore, the volume increases overrides the portfolio improvement. So this, from our point of view, is a proof of the criticism that Basel IV is discriminating good risk and is a [missed] incentive to really steer towards riskier business, which we clearly won't do going forward.

Funding. Not much to comment here. As I already indicated in Q2, we have basically already closed our books. So all our funding needs for this year are fulfilled at a very favorable levels. I think what is interestingly explained in this chart, and Hermann also alluded on that, our deposits are a major funding source and a very stable, so a qualitatively high funding source of our total funding mix. 1/4 of our balance sheet, even close to 1/3 of our total funding needs are covered by these stable deposits, which we have grown over the last couple of years and where we have even increased the share of the sustainable deposits. This is what we will now adjust in our modeling. So we will reflect this increased stickiness going forward, and this will bring us another support to really balance somehow the pressure that we feel on the other side from the [lower-for-longer] scenario.

Balance sheet itself on Page 18. The only thing I would really point at is the Treasury portfolio. You know that this was inflated by the end of last year with the consolidation of DHB that contributed EUR 1.4 billion. Here, we have worked that down again by EUR 900 million throughout the year. We clearly went through the derisking with the reduction of our Italian government bonds by 40%, and this is where we currently stand with an improved structure.

So this is where I would leave it for today. Of course, I'm happy to take your questions. And I would like to hand back to Hermann.

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Hermann Josef Merkens, Aareal Bank AG - Chairman of the Management Board [5]

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Sure. Maybe some words on asset quality, which started on Page 20. So many of you have seen, North American portfolio increased to the 1/3, which is somewhat of our goal. Nothing more to mention here.

Development, as indicated from Marc, further down. And we do not have, for various reasons, not the intention to move into development. And as Marc already pointed out, even the regulatory treatment of developments, in our view, is unfavorable compared to other sort of businesses in the commercial real estate. And hence, our development portfolio will be very, very limited.

In Page 21, you see the breakdown throughout the various countries. Nothing specific to mention here, in my view, so that we could move into Page 22, the defaulted Portfolio. Two main messages here. We already said, the one is that -- relative, remarkable reduction of the NPL portfolio from the accounting perspective now down to 5.6%. And as Marc pointed out, we do expect a further move into the right direction towards year-end here. And I think that's a quite, quite good success in that environment. Although, and Marc pointed that out, we're clearly looking into economic meaningful situations. If we would see deals where we should accept a further discount, simply to wait out, hold position or simply [their] ability to sell [their own] assets economically, meaningfully

(technical difficulty)

we will continue to do that. And as indicated, we already started with that.

Italian portfolio. Not that much on movement so far, and so no major changes here. Same is true for U.K. portfolio. We already announced that we this last year have been faced here with a decreasing NPL portfolio out of our watch list loans. And as far as I remember, still 1 to come or in -- still in discussion, but that's something Marc elaborated on during the Q2 call as well.

From the Treasury portfolio, as Marc pointed into on Page 25, we shifted from BBB into AA, which you could follow here. And a more important topic, which is not that much on the agenda, I would say, so far because as we are talking about capital ratios, you are familiar with Basel III and Basel IV, and Marc pointed out that we are now in the [learning curve] to manage Basel IV ratios as well, which is very good, that we do have the numbers at hand so that we are really prepared once Basel IV is kicking in.

Next theme regulatory wise, which is coming up somewhat, is the ICAAP. Usually seen as an internal model, our observation and following the ECB announcements a little bit, but the ICAAP is somewhat kind of, if I may so, a second pillar alongside with a more normative world of kind of accretive Tier 1 ratios. And by doing that derisking, clearly, that had reflection in the ICAAP model as well. So I would expect that banks are more and more pointing into ICAAP models from 2020, maybe '21 onward, as that internal model is more and more in the focus of the regulator. But as indicated, the next decade is clearly, in my view, full of regulatory changes. No relief to be expected for banks which are operating in that environment.

So on Page 27, if we a little bit start into the outlook 2019, what we're doing is clearly finalizing our strategic group-wide strategic review because, actually, as simply the name Aareal 2020 is somewhat indicating, it has to be followed by something. So we are working on that. Execute the growth strategy for Aareon, as outlined in May 2019, and Marc elaborated a little bit on that, including the assessment of additional M&A opportunities. And just as a reminder, that's what we presented during the [May] was excluded -- there was no M&A activity in, so it was simply self-finance growth program. Clearly, there are M&A opportunities around. And we, as a bank, could support significant and large volume of M&A activities even in the future, although they have been not in the original presented program.

Next important milestone, which we already achieved, is with respect to deposit competition -- not competition, but composition. And Marc elaborated a little bit in detail on that, which is clearly very important. And as you may remember, in 2016, we started with that, and now I would say at the right point in time, given the lower-for-longer interest rate environment, we could -- we clearly could benefit from this initiative. And we should really expect from 2020 onwards a significant change in the picture, how we will present our Consulting/Services segment especially with respect to deposit pricing. And again, there are 2 elements. The one is simply a pricing model, which is clearly something between Consulting/Services and the commercial real estate business, but more important with respect to the stickiness of the deposits we achieved with our clients, which are clearly somewhat overlapped into the Aareon business, is the stickiness of those deposits. We do see an ongoing NII support in the next couple of years, which is a clear supporting sector in that interest rate environment.

On the commercial real estate finance, clearly, we're executing as planned origination and syndication. And last but not least, further NPL reduction to be expected in Q4 2019.

Moreover, clearly, we're looking into opportunities. And forgive us, if there's a opportunity, we will catch it even if it's in the fourth quarter.

From the outlook, clearly, somewhat adjusted, reflecting on the one hand, the derisking. The measurements we've already taken, meaning derecognition income, as explained by Marc, we have to adjust that. Allowance for credit losses, all those derisking activities we already executed, clearly, will lead to a higher range of loan loss provisions we should expect for the year, and hence, adjusted towards that element as well, which leads to an operating profit, which you should really now expect at the lower end of the guidance. Consequently, pretax ROE [and] EPS are following that as well, whereas new business origination is to be expected somewhat on the upper end of the given range.

And traditionally, a little bit of view into 2020 at that point in time. So clearly, we do not have finalized our planning process. And given the environment, we are and remained cautious for 2020. Again, to stress that macro environment, lower-for-longer, or low-risk for longer, I would say, that's a new wording from Marc in the German version, I think. So focus on our extended growth plan in Aareon, but of growing our CRE portfolio, which is one contribution. And just as a reminder, given all our efforts, in that combined business area, Consulting/Services, with our German clients where we see a quite interesting overlap between payment services, deposits and Aareon business, we are now able really to look into the stickiness of our deposits and are allowed to adjust our models, which are not just doing a kind of pricing mechanism, they are contributing into the NII further on, which is, especially in this environment a very, very important factor in our view.

So firstly, clearly, we will optimize our portfolios and we'll initiate some countermeasures against lower-for-longer despite the deposit effect I already mentioned. And against that backdrop, our ambition is still that we should at least slightly improve our operating performance. And with respect to NII, we are somewhat confident that we could combat this environment in 2020. 2021 and onwards remains to be seen, but we are confident somewhat for 2020.

Our aim is to keep costs on a 2019 level. Just as a reminder, if you do your Excel sheets, please keep in mind the Aareon business does have different cost-to-income ratio compared to the banking business. So please keep that in mind and be not surprised if our admin expenses are somewhat above the levels you would anticipate.

As in 2019, and we elaborated a little bit on that, we clearly will assess further opportunities if they emerge within our accelerated derisking initiatives. And as I said, it's like M&A. If there's opportunity we'll do it, but it's hard to plan. So it's not in our guidance. But you could believe that we are just doing that if it's economically meaningful.

So a short summary on Page 29. Robust business, powerful positions in this environment, plus the Aareon is specifically and clearly creating value.

Maybe some closing remarks on the Aareon. It's an integral part and component of the Group. Aareon plays a significant role in that thanks to its excellent growth [prospective] and cross-relationships with our banking business at numerous levels. And I clearly explained a little bit why we think that is very supportive and why it's important on the other hand. And clearly, we continue to have no intention of selling a majority stake in our subsidiary, nor do we plan a full disposal [environment] . This is the strategy we have pursued to date.

And just one little side remark on the majority stake that despite all the strategic type of things, it's technically not useful. Why is it so? It's simply because IFRS accounting methods and regulatory accounting are so different in that area, if I have to move into an equity valuation so that I can't benefit from gains which we may receive in the IFRS under the regulatory perspective. That simply translates into if I can't make use out of gains, then we should not do that because it's, so to speak, a waste of money, which is simply staying still without any usage.

So a short side comment on the majority stake besides all the strategic components I elaborated on.

So in (inaudible), we are concentrating on implementing the growth program presented in May. And I clearly see ourselves in a role as responsible owners to use all sensible options to allow Aareon to realize its full potential in the interest of our company and you, the shareholders, as well.

So thank you very much for listening, and we're clearly happy to take your questions. Actually, I think we will answer them if they occur, and Marc and myself are happy to take them.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question comes from the line of Britta Schmidt with Autonomous Research.

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Britta Schmidt, Autonomous Research LLP - Non-Designated Member [2]

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(technical difficulty)

questions please. On the usage of the deposits, can you maybe elaborate a little bit? Does that mean that you would be willing to add more new business [under] with stable deposits? Or would you consider undertaking less refinancing?

Also, on the stable deposits, what is the share of stable deposits that you could use? And would you also consider modeling them in terms of investing into longer-dated treasury portfolio? Maybe you can give us a color on that.

And then secondly on the impact of the derisking, you've restated the impact of the calendar provisions for ECB guidelines down from EUR 200 million to EUR 300 million to EUR 150 million to EUR 250 million. Is that reflected in the Basel IV capital provision? And with further derisking until year end, do you expect this number to go lower?

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Marc Oliver Hess, Aareal Bank AG - CFO & Member of the Management Board [3]

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Yes. Britta, thank you for your question. I'm trying to answer them. Regarding the deposits, first question was would we refinance more new business with deposits? Well here, of course, new business outlook and the decision whether we want to grow the portfolio is not driven from the liability side, so this is driven from the market. But maybe your second question already leads into the right direction, does that compensate for different kind of funding needs? Yes, it does. Yes, it clearly compensates for our necessity to go on an unsecured basis to the market, so it will decrease our unsecured funding somehow. We are increasing or we have modeled the stickiness and revised the modeling again after the increase of the deposit base itself and, of course, the improvement of the mixture. So we would now say that 50% to 60% of those deposits are sticky, and that then, via the decreased funding and also from the interest rate sensitivity point of view, so if both liquidity and interest rate sensitivity stickiness improves our interest expenses. And therefore, it's a supporting factor, as we just outlined in this lower-for-longer scenario.

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Britta Schmidt, Autonomous Research LLP - Non-Designated Member [4]

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Can I just ask on that? You also said that you'll reallocate the funding. Would you consider splitting Consulting and Services division into the funding side, allocate that to property finance and then have Consulting and Services as essentially on their own?

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Marc Oliver Hess, Aareal Bank AG - CFO & Member of the Management Board [5]

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Well, what we will consider is, and I think Hermann mentioned, that's our internal pricing model. So as we are currently incentivizing the division only on a secured basis, we would now shift towards an unsecured pricing. It's not yet fully decided in which composition. So this will start from Q1 2020 onwards. There's still some time to go to take this decision, but the segment will clearly benefit from that.

So from the segment point of view, it's 2 changes. One is, as I said, the pricing -- the internal pricing itself, and the second is the modeling, which is an improvement not only for the segment, but also on an underlying basis in the operating income via less interest expenses.

Then your questions about potential provisions. Yes, you know that there has been a revision by the EBA. I think it was reflected in the ECB. So we have now a longer period that was extended to 10 years for the new business. And as you have clearly spotted, that brought the range down that we indicated before. I think before, it was EUR 200 million to EUR 300 million, now it's EUR 50 million less. So EUR 150 million to EUR 250 million, reflecting, let's say, the new business. And yes, we have already taken that, I think, even from Q2 on within our capital calculation both for Basel III and Basel IV. So overall, that meant a reduction from a EUR 35 million contribution to potential provisioning per annum under the old regime to now just below EUR 30 million. So quarter-by-quarter, the effect is marginal.

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Operator [6]

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Next question comes from the line of Benjamin Goy with Deutsche Bank.

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Benjamin Goy, Deutsche Bank AG, Research Division - Research Analyst [7]

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Two questions, please. One on asset quality and one coming back to deposits and NII. So EUR 20 million was the loan-loss impact from the active de-risking, and Italian NPLs are only marginally down in the quarter, so should we expect then first booked in Q2 and then the derecognition on the balance sheet happens in Q4?

And then the second question, now with a substantial benefit coming from as you just said from the deposits. Is it fair to say there is quite significant pressure in the rest of the business [than] on the NII to keep it stable slightly up going forward? Maybe you can add some color on that.

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Hermann Josef Merkens, Aareal Bank AG - Chairman of the Management Board [8]

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Sorry, but (inaudible) has already started. So maybe, if I may start with Italy, clearly, you should expect some positive, hopefully, movement in that NPL portfolio in Q4, and clearly, we somewhat "pre-provisioned" the one or other case. Although if, for example, one would pre-provision former development case with some syndicate where the customer and client, first of all, have to change his mind and to understand that it may take some time to really execute that. But as you rightly said, it's the kind of pre-provisioning, so to speak, [to add] and to execute the accelerated de-risking. Maybe the second question if you...

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Marc Oliver Hess, Aareal Bank AG - CFO & Member of the Management Board [9]

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Yes, happy to take it. Your question was regarding lower for longer the effect [indiscernible] , and to what extent this could be balanced by the new modeling and if there are further pressure points. Well first of all, I think, we all know that the longer the lower for longer persists, the higher the pressure is.

We just said that this year, including the effects from the de-risking in the treasury portfolio, we had the dilution of roughly EUR 10 million. The reference point is always the forward rate of last year, November, somehow, that were the basis of our planning. So you can see this year, it had some effect, but it had not had a great effect, and we were able to compensate for that, especially with a better margin development in the commercial real estate loan book than we originally anticipated.

So as just said, the lower -- the longer the lower for longer persists, the higher the pressure will be, and therefore, here again taking as a reference the forward rates of last year, we calculated that this would be, let's say, somewhere between EUR 20 million to EUR 30 million next year just the NII effect here from the lower rates.

And...

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Hermann Josef Merkens, Aareal Bank AG - Chairman of the Management Board [10]

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Without compensating.

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Marc Oliver Hess, Aareal Bank AG - CFO & Member of the Management Board [11]

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Without compensating, just a mathematical calculation, and as Hermann just said, nevertheless, we are, at least, let's say, positive that we can balance this for next year with all the countermeasures that we are taking.

One countermeasure is the modeling of the deposits. Here, we are in a very favorable situation that we can now collect the fruits of the really improvement of the structure that was a key of our strategy in the deposit business over the last couple of years. So I would say that was good timing, but this is not the not only effect, however, a quite important one. We have other initiatives, be it let's say on the funding structure and other [senses] , also, of course, let's say, allocating the commercial real estate portfolio, other property types and regions, but this is something that we will be happy to outline to you in February. As just said, we are just in the middle of the planning process, so this is all preliminary. We have some indications, but we are somehow in a good mood that, for next year, NII should stay stable or at least -- or even be up slightly despite of that very challenging environment.

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Operator [12]

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Next question comes from the line of Johannes Thormann with HSBC.

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Johannes Thormann, HSBC, Research Division - Global Head of Exchanges and Analyst [13]

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So I have 3 questions as well. First of all, could you elaborate how much of the French deal, the hotel deal will be syndicated? And then it seems the margin impact in Q3 on pre-FX margins, how much margin uplift could we expect on the remaining business review?

Secondly, looking at your guidance of EUR 30 million LLP additional LLP for the de-risking of the portfolio, should we expect this as one and only step, or should we expect a row of several steps also going into the next year in terms of cost of risk?

And the last thing is, yes, I'm wondering, why you changed the deposit pricing just now the lower-for-longer rates has been in place for a long time. And do you have any indications for the impact of the shift of revenues between -- or from the banking business towards the Consulting and Services business?

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Hermann Josef Merkens, Aareal Bank AG - Chairman of the Management Board [14]

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Johannes, thank you for your questions. If I may start with your last question. So it's really a project, which has been run here in the bank for now, I'll say, 1, 1.5 years. It's -- so nothing you could do simply by pushing a button because you have to run a lot of exercises to look into how to deal with that. And as Marc indicated, we are now finalizing that because simply it was one milestone in our 2016 program, and we executed on the composition of the deposits, and accordingly, we could start to look into whether our overall -- modeling, which is, now I don't remember it exactly, but some 5 to 7 years old, whether overall modeling is reflecting the situation correctly. And if not used the step-by-step approach meaning pricing, and then we are looking into the stickiness, so we have done one-in-all, so to speak, approach looking into pricing in between these segment and the stickiness of the deposits as well. So it's not a kind of decision, if you like. So it's not just that Marc presents something, it's really a model change which has to be validated.

We are a regulated entity as everybody knows I think, so it had to be prepared meaningful. And now we are -- as we come to the end of our Aareal 2020 strategic program, somewhat in the position to reflect that into our overall pricing, but more important in my view is use of deposits. So that's the reason why then now, so to speak, we're doing that move.

Your first question was with respect to the French portfolio. Clearly, we do have here that are 2 deals, some EUR 900 million. And what was then presented on a -- a little bit -- somewhat 50%.

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Marc Oliver Hess, Aareal Bank AG - CFO & Member of the Management Board [15]

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Just about 50%.

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Hermann Josef Merkens, Aareal Bank AG - Chairman of the Management Board [16]

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Just about 50% should be syndicated until year-end. And clearly, the rest of the portfolio margin -- or the new business margin is clearly above the average guidance of -- the upper end was somewhat 190 basis points, but we're passed that because that deal dragged down the Q3 margin significantly.

With respect to the accelerated de-risking, clearly, we have done some de-risking activities. And as I indicated, in June our preliminary figures, I think, which will be more and more important, but that's not just on us. I would think that most of the banks are more and more moving into that area. It is more important to look into whether it's economically meaningful to sell loans instead of doing this type of collateralization that we have been very successful with.

And Marc pointed out a deal towards -- in Copenhagen, I think, during Q2, which was a very favorable support for our loan loss provision. So we have been here with our clients for a long while, which turned out as a positive result in Q2. And if I say for a while, I'm talking about -- above 5 years.

In that regulatory environment, we are now moving in simply next, in my view, for [this related to provisioning, no sense] , and you have to outright -- whether outright -- whether you simply pay this loan or do that for a while, taking clearly risk or whether you should execute. And I think I elaborated a little bit during the preliminary figures somewhat normally. We are talking here about discounts and constantly if that discount is meaningful and makes economic sense, then we will execute.

With respect to your question, whether you should, or you will see here numbers in next year as well? Maybe as I said, it's somewhat like M&A, if an opportunity is there, we'll grab it. But clearly, we will not move into this famous 70% discount hedge fund business because to be honest, that makes still no sense. And so if it's meaningful and economic sensible, then we will do it. And clearly, this could lead to additional provisioning in 2020. I'm just looking for the right numbers for 2020 as may be for the Q4.

I think that there are your 3 questions if I have that correct.

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Operator [17]

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The next question comes from the line of Nicholas Herman with Citigroup.

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Nicholas Herman, Citigroup Inc, Research Division - Assistant VP and Analyst [18]

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Three, if I may. One is a follow-up. But firstly on just coming back to the deposits. So prior to this new development, what percent -- can you just remind us what percentage of deposits have been classified as sticky? You referenced that you now see 50% to 60% of deposits as being sticky, what is at par? And how quickly do you envisage being able to fully utilize the new level of deposits in funding your new -- your real estate -- your new business?

And secondly, on gross margins, can you just provide us an update, please, on the outlook for margins by region and products? And how much you continue to feel competitive impacts? I mean your commentary is quite cautious, given the macro backdrop. Are you still also cautious on medium-term margin trends?

And then finally just quickly on treasury. You recognized EUR 10 million this quarter from unwinding your Italian government bonds portfolio. Could you just give us a rough idea of how much-unrealized gains are standing on the overall treasury portfolio, treasury bond portfolio, please?

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Marc Oliver Hess, Aareal Bank AG - CFO & Member of the Management Board [19]

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Yes, thank you, Nicholas, for your questions. I would like to take the one of -- on deposits and on treasury. Well on deposits you asked how many, volume-wise, of our deposits, would now be classified as sticky compared to the old modeling. It is not a great deal. So we are not talking about a fundamental difference. It's roughly 10 percentage points more. How would we utilize them, here, I want to point to what I just said, it will be a compensation for unsecured funding. So we will need less unsecured funding to that respect.

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Nicholas Herman, Citigroup Inc, Research Division - Assistant VP and Analyst [20]

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And what is the funding cost difference there, sorry I just -- roughly?

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Marc Oliver Hess, Aareal Bank AG - CFO & Member of the Management Board [21]

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Roughly, 60 basis points. If we are calculating unsecured funding currently with the mix of preferred and nonpreferred, we're talking about 60 basis points plus.

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Nicholas Herman, Citigroup Inc, Research Division - Assistant VP and Analyst [22]

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Great.

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Marc Oliver Hess, Aareal Bank AG - CFO & Member of the Management Board [23]

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And with regards to treasury, absolutely correct. Yes. we were able to realize some reserves here; however, and I think, I hope it came across in our presentation that just was not a plain vanilla sale. We really restructured our complete treasury book. We improved the quality. We looked at the correlations of different exposures here, and at the end, given that we took out BBB exposures, we also were able to take out some bonds, yes, even improving the [weighting] in the ICAP, and I think this is the very important part. It's not a realization just of any unsecured -- of any reserves. Yes, it was really a structural change with an improvement of the overall structure of that book. And therefore, please allow me, I would also not like to just give you a number regarding the hidden reserves in our treasury book because this is not our intention.

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Operator [24]

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Next question comes from the line of Tobias Lukesch with Kepler Cheuvreux.

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Tobias Lukesch, Kepler Cheuvreux, Research Division - Equity Research Analyst [25]

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Three questions from my side as well. First, touching again on the treasury portfolio, you mentioned the optimization. So I was just wondering, do you have a new minimum target in mind? I have in mind that in the past, you argued yes, it's a very large portfolio for the size of the balance sheet. So this may be not from an optimization perspective but maybe really from adding nicely to the P&L in the coming quarters. How much volume would you say is still available?

And secondly, with regards to the reinvestment, what is your current reinvestment policy with regards to yields and also duration-wise?

Secondly, on Aareon, you mentioned some potential M&A opportunities that may come along. I was wondering, you mentioned or it was today reported via newswires that you considered a full sale, but this is not what you're expecting, and I'm wondering, how thoroughly was the business interdependencies finally or have [it] been assessed? And to what extent did you rely on third-party expertise on that side also to please some activist or to have negotiation power with regards to activist investors?

And thirdly on the dividend policy, could you maybe give us an update on your current considerations with regards to the supplementary dividend, and will it be more on the 20% or rather on the 30% side?

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Marc Oliver Hess, Aareal Bank AG - CFO & Member of the Management Board [26]

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So again, I would like to take your questions regarding the treasury portfolio. As you can see on page 25, we are currently at EUR 7.8 billion. So as I explained, we have reduced it again after the consolidation effect of DHB, which clearly inflated it. And our target is to stay around EUR 8 billion. This is clearly driven by our liquidity reserves that we need to fulfill our liquidity requirements. So this is something that we are optimizing here. So let's say if we are not seeing any major inflow on the deposit side, so clearly, this is always communicated, then we would somehow stay at level here.

Have we concluded the reshuffling, let's say, of the portfolio, not fully. Yes, we are about to conclude that by the end of the year. This is at least our perspective. What we have completed is the reduction of the Italian government bonds. I think, here, we have clearly used the window that has been opening throughout this year with the governmental change in Italy and spreads contracting and so on and so on. So here, as said, we're down by 40%, and we are now at a level where we feel comfortable within our BBB exposure.

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Hermann Josef Merkens, Aareal Bank AG - Chairman of the Management Board [27]

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And your second question was -- what's the (inaudible) activities here. I just entered into that the original plan presented by Aareon management in May was to do a self-financed growth program, which is moving in the right direction without any M&A on the Aareon end. And clearly, we are able and will support Aareal Bank AG or move potentially upcoming M&A activities from the Aareon and simply wanted to spread, that not rule out that the Aareon will do some top of the already presented planned M&A activities maybe even until the end. So that was my point to compare the potentially upcoming M&A activities with the original plan.

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Tobias Lukesch, Kepler Cheuvreux, Research Division - Equity Research Analyst [28]

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Yes. Sorry. And my point was more on the potential partial sale of Aareon to an investor, right? Any thoughts around that topic? And I mean, I think, you've been quite busy in dealing with the activist investors over the past weeks and months, and I was just wondering like how much more details you may have shared, or may now be able to share with the investors' world around the Aareon stake and a potential valuation of that?

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Hermann Josef Merkens, Aareal Bank AG - Chairman of the Management Board [29]

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So that -- so variation always, so to speak, something which had to be carried out carefully, and there are a lot of indications, I'll say, so forgive me, if I'm not being part of speculations. But on the other hand, clearly, what I could say is that we've run a decent and in-depth analysis. And one thing you know from us at the management. So we are not seen as the management which is not looking into the very details, I would say, so we are trying to be proactive looking into details and evaluating situations. And one result, so to speak, is, besides all the strategic -- and I will refer to that in a second that for example, a majority sale, if I may so, simply makes no sense. Because in equity valuation, you do have different treatment in the IFRS accounting and regulatory accounting, which would need to [effect] that you can't use out of the gain. And hence, again, it makes no sense to undergo that type of exercise.

And with respect to full disposal, as I stated, so we do [not] have an intention of selling or do full disposal in line with the strategy we pursued to date. And I think we made clear during the call how important and supportive the overall business is, and having said this, as a responsible owner, clearly, we are looking into all sensible options to allow Aareon to realize its full potential.

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Jürgen Junginger, Aareal Bank AG - MD IR [30]

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And as we're running out of time, we're focused on the analyst. We're taking our final question from Britta, and then we'll do the roadshows and available for investors. So you can call us for sure, or we will see you then in other days to come. So Britta, you have the final word.

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Britta Schmidt, Autonomous Research LLP - Non-Designated Member [31]

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Yes. So I just wanted to pick up actually on that last point to understand the difference between IFRS and regulatory accounting. Are you referring to the potential consolidation [circa] with regards to Aareal not being the part of this CET 1, or can you maybe elaborate on that a little bit?

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Hermann Josef Merkens, Aareal Bank AG - Chairman of the Management Board [32]

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All right. So works like, but that's just few weeks, so to speak. And again, more important behind the technique is, first of all, the strategy. But here, we clearly have kind of a disadvantage to think to majority. You would -- clearly would recognize a gain hopefully, on the shares we are selling. On the same -- at the same time, you would recognize a gain of shares you are keeping, but that gain has to be deducted from the Common Equity Tier 1 from first -- second so to speak. So and that makes that type of yield structure unfavorable because you would look what you win and so, and you can't make use for -- out of that gain, which would clearly drive ROE down. It's unusable capital, and you would have huge difference between IFRS and regulatory capital, which is still high, but would be even higher. Hence, we think within that technical detail, if I may say so, which was very, very important to know in our case, it makes no sense to follow a majority sale.

And as I pointed out, there are some strategic things as well, but that's the one thing where we clearly are of the opinion majority makes no sense.

So thank you very much for listening. Thank you for your questions, a little bit mixture between strategic and detailed questions. But at the very end, hopefully, our answers were helpful to that extent. I take a view -- I think we presented a robust business. We are very well positioned. Despite the environment, I pretty much think (inaudible) of the original guidance, including the EUR 30 million, we already invested. We could very much look forward in the next upcoming year and month. And thank you very much for your attention.

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Operator [33]

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Ladies and gentlemen, your conference has now concluded, and you may disconnect your telephone. Thank you for joining and have a pleasant day. Goodbye.