On the surface, the Bank Resolution and Recovery Directive (BRRD) looks unequivocally negative for banks’ senior credit ratings. “What we’re seeing with BRRD and an array of other regulations and legislation is a desire from the authorities to reduce the need for bailing out banks by encouraging loss absorption elsewhere,” says Michelle Brennan, criteria officer at Standard & Poor’s in London. “As a result, our view is that while we don’t rule out support for senior creditors in some circumstances, we expect it to be much less certain than in the past.”
This echoes the consensus view of the rating agencies, all of which have taken action in recent months on senior debt ratings to reflect the fact that it can no longer be assumed that they will enjoy the cocoon of government support. Fitch led the way at the end of March, revising its outlook to negative on the long term issuer default ratings of 18 commercial and 18 state supported European banks.
“The likelihood of a downgrade or downward revision is based on further progress being made in implementing the legislative and practical aspects of enabling effective bank resolution frameworks, which is likely to reduce implicit sovereign support for banks in the EU,” Fitch explained at the time.
S&P followed a month later, revising its outlook on 15 European banks from stable to negative, reflecting the view that “extraordinary government support is likely to diminish as regulators implement resolution frameworks”.
Moody’s, meanwhile, was the last of the big three agencies to wield its axe over the outlook for European banks in response to BRRD. In late May, it advised that “the balance of risk for banks’ senior unsecured credit has shifted to the downside,” changing the outlook on 82 banks to negative.
Support ebbs away
Europe’s leading banks certainly appear to be recognising that they will increasingly need to prepare for an environment in which the government support they enjoyed in the past has ebbed away. “We don’t expect to get any government support for our senior unsecured credit rating,” says Erik Schotkamp, capital and funding managing director at BBVA in Madrid. “This means we are now having to defend our senior debt rating based on our own total capital ratios.”
It is this recognition, say bankers, which means that the assumption that the regulatory environment is universally negative for senior unsecured credit ratings and investors may be an over-simplification. Austen Koles-Boudreaux, executive director at Morgan Stanley, says that the focus on the negative impact on senior ratings arising from BRRD may be obscuring the more positive dynamics arising from the broader bank capital debate.
“Up to now, the main focus of the rating agencies has been on the progressive withdrawal of government support for banks in Europe, the limits placed on governments’ ability to bail out creditors, and future risks of senior bail-in” he says. “But while the agencies now have negative outlooks in place on banks across Europe to reflect this development, there seems to have been less of a focus on the improvements being made in the same banks’ financial profiles.”
More specifically, says Koles-Boudreaux, there is a question mark over how fully rating agencies are factoring in the continuing efforts taken by banks to strengthen their capital positions and liquidity as part of the changing regulatory landscape — limiting the risk of senior bail-in with or without public support. “We believe there is a positive element of the bail-in agenda which the agencies have not yet clarified their views on, namely the buffers that banks are building up, what this means for their loss absorbing capacity, and the extent to which this could limit senior bail-in risks in the same way as government support at the beginning of the crisis,” says Koles-Boudreaux. This also raises the risk of timing problems, he says, with banks potentially downgraded due to support assumptions at the same time as their financial profiles are being reinforced.
James Longsdon, managing director and co-head of EMEA financial institutions at Fitch Ratings in London, says that total capital ratios are likely to become an increasingly important ratings consideration going forward in countries where the bank resolution agenda is more advanced. “We rewrote our master criteria this year, and the only substantive change we made was to allow for a scenario where large buffers of junior debt could lead to the senior debt being notched up,” he says. “We haven’t yet notched any senior debt up, and we have to be careful not to double count, because part of the capital base is already factored into our viability ratings. We also need to ensure that we take a long term view of banks’ capital management plans because a bank with a large stack of junior debt now may still choose to retire some of it. But our framework for senior debt ratings now allows us to take account of issuers’ total capital position.”
Undoing the damage
Importantly, the Moody’s update at the end of May also acknowledged the emergence of a positive feedback loop between bank and sovereign ratings, which may be starting to undo some of the damage caused by the negative loop during the crisis. “The creditworthiness of EU sovereigns may, over the longer term, benefit from the BRRD/Single Resolution Mechanism (SRM) package, and, more broadly, the steps taken by the EU towards a banking union,” Moody’s commented. “The measures aim to reduce the risk that bank-related contingent liabilities will crystallise on EU government balance sheets in a future banking sector stress scenario.”
The volatility of the regulatory environment has made rating contingency capital instruments notoriously complicated. Barbara Havlicek, senior vice president and team leader of the hybrid capital group at Moody’s in New York, says that since the inception of the market for CoCos five years ago, the agency has drawn a distinction between high and low trigger instruments, which it regards as non-viability contingency capital (NVCC).
It was not until May 2013 that Moody’s began to rate CoCos, and even then it confined its ratings to low-trigger NVCC. “We put in place a moratorium on rating these instruments in 2010, because we felt that lack of regulatory clarity meant there was insufficient visibility as to when equity conversion or write-down would occur,” says Havlicek.
“Additionally,” Havlicek explains, “we did some investor outreach when the first CoCos were issued. The feedback from some investors was that they did not want us to rate these instruments because they believed the conversion feature made them inappropriate securities for fixed income investors. They were also concerned that CoCos would make their way into indices, forcing investors to hold them.”
For Moody’s, both hurdles to rating low-trigger instruments have melted away in recent years. “By May 2013 we had a much better sense of how regulators were looking at NVCC, which we began to rate after putting out a request for comment,” says Havlicek.
Adapting to change
By 2013, too, fixed income investors’ resistance to loss-absorbing instruments was also being addressed. “A triple-B issue rating would be a strong marketing point, but investors can accommodate double-B ratings,” says Alex Menounos, managing director and head of EMEA syndicate and co-head of EMEA FIG FICM at Morgan Stanley in London. “Investors have been able to adapt existing mandates to accept sub-investment grade, they have leveraged access to high yield funds and in some cases have created dedicated AT1 funds, designed to avoid ratings restrictions.”
The sub-investment grade rating on banks’ AT1 instruments is a function of the notching approach that each of the agencies takes in rating banks’ most deeply subordinated loss-absorbing instruments.
The agencies themselves point out that there is no one-size-fits-all formula for notching AT1 instruments, with Longsdon saying that Fitch maintains a degree of adaptability on notching incremental non-performance risk. “On top of two notches for severity of loss given default, our base case is to add three notches for incremental non-performance risk relative to the anchor viability rating. However, in the case of a bank with particularly thin buffers or low flexibility to keep itself out of the dividend restriction buffers where MDAs kick in, we need to have the flexibility for additional notching,” he says.
Bankers say that while sub-investment grade ratings no longer appear to present a complication for investors, potential volatility of ratings on loss-absorbing instruments may. “There is a lot of criteria change at the moment which can be problematic for issuers and investors,” says Koles-Boudreaux at Morgan Stanley. “In particular, the ratings criteria for newstyle hybrids, both high and low trigger, is something of a moveable feast in 2014.”
Subordinated hybrid jigsaw
That volatility is driven in part by the agencies’ increased recognition of the impact of regulatory risk on coupon payments or other triggers being activated well in advance of point of non-viability. “While much of investors’ focus was initially on how close a bank is to non-viability, in our view the question of when tier one and some tier two instruments can be expected to engage in absorbing losses on a going concern basis is now a key risk,” says Brennan at S&P. “This was the basis of the Request for Comment (RFC) on our rating methodology for bank hybrid instruments which we issued in February.”
Moody’s also has an RFC now outstanding on what Havlicek describes as the last piece in the agency’s subordinated hybrid jigsaw, which is its methodology for high trigger CoCos, which it does not yet rate. “We believe high-trigger securities where conversion to equity or write-down can be triggered well in advance of the point of non-viability are a completely different animal from NVCC instruments,” she explains. “We have now developed a model which is anchored in our standalone assessment of bank financial strength and measures the probability of a bank-wide default and the probability of a trigger breach to capture both risks of high-trigger instruments.” The RFC closed in early June and Moody’s expects to release the results by the end of the month.
Potential ratings volatility is also keeping investment banks’ ratings advisory teams busy. Koles-Boudreaux leads the Morgan Stanley group that advises financial institutions on the agencies’ criteria. “Our work involves navigating the rating agencies’ criteria and optimising the dialogue between our clients and the agencies,” he explains. “We know that there could be significant downside risk for European banks’ senior ratings over the next 18 months given the government support question,” he says. “The issue for our clients is, how can they address this challenge, what can tangibly be done in the short term and how can we avoid a new round of negative rating actions in the European bank space?”