An EC legislative proposal for bank recovery and resolution published on Wednesday is credit negative for unsecured bank bondholders but credit positive for European covered bonds and in the long run also for government bondholders, said Moody’s today (Monday), although an analyst said impacts specific to structured covered bonds should be borne in mind.

The European Commission’s draft directive proposes a range of tools to deal with struggling or failing banks in an attempt to avoid taxpayer funded government rescues but protect financial stability, including allowing member states to impose write-downs or conversions to equity on liabilities such as subordinated debt and senior unsecured debt.

Moody’s analysts said that although the exact provisions of the plan will remain uncertain until final adoption by the EU and individual countries, the proposal illustrates the intention of governments to impose losses on bank creditors outside liquidation, and that the clear intent of many governments to share the cost of future bank bailouts with creditors makes support less predictable.

The proposal is credit negative for unsecured bank bondholders, they said, but will in the long run be credit positive for government bondholders as it will reduce the likelihood and size of potential taxpayer-funded bailouts, which can place considerable strain on public sector balance sheets.

The credit profile of European covered bonds also stands to benefit, according to Volker Gulde, vice president, senior analyst at Moody’s. This is because the draft directive – Article 38, Paragraph 2 (b) – explicitly excludes all secured liabilities of a failing bank from being bailed-in, with covered bonds clearly meeting the definition of a secured liability.

“This exemption will apply in all EU member states, since the directive states that any potential write-down facing unsecured creditors ‘shall not’ be exercised with regards to secured liabilities,” said Gulde.

In addition, he noted that covered bonds are the only secured liability to be granted an exemption from the possibility that, if secured liabilities exceed the value of the assets securing them, the excess amount may be subject to bail-in “where appropriate”.

Article 38 specifically grants individual member states the option of excluding from the bail-in covered bonds as defined by directive 86/611, and Gulde said that Moody’s considers it unlikely, particularly in jurisdictions with long-established covered bond markets, that regulators would not take advantage of this option.

Florian Eichert, CA-CIB

Florian Eichert, senior covered bond analyst at Crédit Agricole, agreed with this assessment, but said that the proposal came with a “bit of a twist” and that investors should still be aware of the potential bail-in of the residual senior unsecured claim on an issuer in the case of non-UCITS-compliant covered bonds from the EEA, as these are not eligible for the aforementioned exemption.

“At the moment there are only very few non-UCITS compliant covered bonds remaining in the EEA but future structured covered bonds backed by alternative assets such as SME loans for example would fall under this rule,” he said.

Eichert also warned that although Moody’s has said the proposed bail-in framework is positive for covered bond holders, the possibility of the rating agency moving its bank ratings closer to the respective bank financial strength ratings could be negative for covered bond ratings.

According to Gulde the EC’s draft directive also contains operational benefits for covered bonds, via elements that strength the continuing operations of the issuing bank throughout any resolution process.

“The option of appointing a special manager for a limited period in advance of insolvency and exempting unsecured claims of employees from write-down will help preserve issuer operations and increase the probability of timely payments,” he said.