Larger banks could suffer under CRD IV proposals, according to Fitch, with their covered bonds facing higher capital charges and those using an internal ratings based (IRB) approach applying higher risk weights to their holdings of covered bonds than smaller financial institutions.

The rating agency welcomed a planned change in the standardised approach whereby risk weights for covered bonds will be based on their ratings rather than sovereign or issuer ratings, but criticised their treatment under proposed amendments to the IRB approach.

Fitch’s analysis found, for example, that banks using the standardised approach will face lower capital charges for all triple-A rated covered bonds except for those issued by an institution rated AA+ or higher (see chart). And of the programmes rated triple-A by Fitch, only one financial institution is rated AA+ or higher (NRW Bank, AAA).

“Unlike the standardised approach, the IRB approach remains largely unchanged under the new proposed CRD framework, with no explicit direct link made to the covered bond rating,” said the rating agency. “In Fitch’s opinion, the use of an issuer PD (probability of default) combined with an issue-specific LGD (loss given default) is logically inconsistent, particularly when the standardised approach is proposing to use the covered bond issue rating as the basis for determining risk weights.”

Large issuers – who may be institutions more likely to be using the IRB approach – could also have higher risk weights applied to their covered bonds, according to Fitch, through the introduction of a new component to the calculation of IRB risk weights, the Asset Value Correlation (AVC).

“As most covered bonds are issued by banks which are regulated institutions, those covered bonds will attract a 25% increase in the correlation charge which will result in higher capital charges,” said Fitch. “Indeed, the increase in the value of the correlation parameter is part of the changes to the Basel framework: it was driven essentially by the close links between banks and their losses incurred during the financial crisis.

“The CRD IV rules will apply the increased correlation charge to all exposures to large regulated financial entities. Large regulated financial entities are defined to be entities with total assets greater than or equal to Eu70bn.”

Fitch found that, depending on the rating of an issuer, the capital charge for covered bonds issued by a “large” bank could be as much as one-third higher than that for covered bonds issued by a “small” bank, especially when the issuer is highly rated (see chart).

Risk weights for covered bonds under the standardised approach will be lower, according to Fitch, particularly in light of downward rating pressures faced by sovereigns and issuers. However, it said that incorporating a greater number of rating steps would make for an improved framework – the proposals use rating bands (such as AAA to AA- and A+ to A-) rather than distinguishing each notch.

The bulk of Fitch’s analysis, including the above aspects, focused on CRD compliant covered bonds. Regarding non-CRD compliant covered bonds, it said that EU banks using the standardised approach would apply capital charges to CRD compliant covered bonds half those applied to non-compliant covered bonds, and would also be applying lower capital charges to CRD compliant covered bonds than would non-EU banks. The picture is much more complicated when it comes to the IRB approach, and we would recommend reading the Fitch report in full.