An ICMA CBIC call for rating agencies to adapt their covered bond approaches in the face of changing regulation has been welcomed by several analysts, while rating agencies have said they will engage with the feedback but that they need more regulatory clarity.

The Covered Bond Investor Council, a permanent working group of the International Capital Market Association Asset Management and Investors Council (AMIC), wrote to DBRS, Fitch, Moody’s and Standard & Poor’s last Wednesday (7 August) with a four point wishlist for how rating agencies should mould their covered bond rating methodologies in the context of changing regulation.

Rating agencies should adapt their approach to better reflect new regulation and support for covered bonds, said the CBIC, and rethink the relationship between bank senior unsecured ratings and covered bond ratings. (See here for previous coverage of the CBIC’s letter.)

Of the four rating agencies the CBIC wrote to, DBRS and Standard & Poor’s shared some early reactions with The Covered Bond Report, Moody’s declined to comment, and Fitch said it will speak directly with the representatives of the CBIC.

Fitch also referred to a statement it made on 23 July about the impact of a new EU bank recovery and resolution directive (BRRD), in which it said that it is not planning any near term covered bond criteria changes, but that the bail-in of senior debt could widen the difference between covered bonds and senior unsecured debt ratings.

Moody’s has previously – as early as December last year – flagged the possibility of it repositioning its reference point for an issuer default as a result of bail-ins, saying it does not necessarily translate to an increased risk of issuer default in relation to covered bonds.

Vito Natale, senior vice president, EU covered bonds, at DBRS, said that he appreciates the CBIC’s view, even if it is too early to determine the impact of bail-in on covered bond ratings.

“Their position is understandable in the sense that our current methodology may seem not yet ready to take account of the regulatory changes that are coming up,” he said. “But it is difficult to say what will happen to the covered bonds if it is still not yet clear what the impact of bail-in on bank bonds will be.”

Natale said that no position has been taken yet by DRBS on the impact of bail-in on bank ratings, although discussions are underway.

S&P sees bail-in leeway

Karlo Fuchs, senior covered bond analyst at Standard & Poor’s, said that the CBIC is a body with an “important voice” and that the rating agency takes its comments seriously.

“We always appreciate comments made to rating agencies and we will investigate to what extent their concerns have to be reflected in what we do,” he told The Covered Bond Report. “We will take the comments into account if we realise that some of them are not already factored into our criteria and should be.”

As concerns the rating implications of bail-in regulation, Fuchs pointed out that S&P’s financial institutions team communicated the rating agency’s prevailing stance with a comment in early July, namely that the an agreement reached by EU member states at the end of June would not trigger immediate changes to S&P’s bank ratings, and that national governments still retain substantial flexibility in deciding how to resolve failing banks.

“Our financial institutions colleagues see enough leeway for bail-in to not necessarily be the norm and that governments could still be the first recourse for support,” said Fuchs.

As other rating agencies have emphasised, he said that S&P needs to wait for the final bank recovery and resolution directive before making any changes.

Other desires expressed by the CBIC have to be carefully weighed, according to Fuchs, such as the call for systemic support to be given greater weight. The investor council acknowledged that this involves a qualitative element, and Fuchs said that this aspect needs to be treated with caution given the subjective nature of qualitative factors. By lending greater qualitative weight to covered bond ratings rating agencies would be opening themselves up to potential accusations of inconsistency and a lack of transparency at time when they are under regulation, said Fuchs.

The CBIC also called for rating agencies to “exercise caution” when it comes to taking action on covered bond ratings after a bank senior unsecured downgrade, but Fuchs suggested that investors also lose out if rating agencies hold off on following up on negative senior unsecured or issuer rating actions.

“If you wait to take action you will miss out on warning signals and then there is a risk of a sudden rating cliff, which is what everyone wants to avoid,” he said. “We think that having the link to the issuer and making sure there are warning signals and that there is a move in the covered bond rating has some value.”

Analyst backing

Several covered bond analysts have welcomed the investor council’s comments.

RBS analysts said that they “highly support” the CBIC’s request that rating agencies amend their methodologies in light of recent bail-in regulations, and UniCredit analysts said they are “100%” behind the investor council in that rating agencies have to adapt quickly to the changing regulatory environment.

The UniCredit analysts acknowledged that incorporating the implications of potential bail-ins in ratings is a challenging task, but said that it must happen in order for ratings to retain value.

“Otherwise, the credit assessment of covered bonds is prone to fall victim to a garbage in- garbage out problem,” they said.

For them, a bank’s unsupported rating should be the starting point for the credit assessment of covered bonds.

Florian Eichert, senior covered bond analyst at Crédit Agricole, sympathised with the CBIC’s comments. He said that while rating agencies are already fulfilling some of what the CBIC has called for, such as continuously updating their methodologies and taking account of sovereign support for covered bonds, changes need to be made, in particular by breaking the link between covered bond and senior unsecured ratings.

“The political will to support covered bonds in general is bigger today than it has ever been, while support for senior unsecured debt has declined and will continue to do so once bail-ins are fully here,” he said. “Linking covered bond ratings to senior unsecured ratings doesn’t make any sense as that would indirectly be factoring in less support for covered bonds via the lower senior rating, when support for covered bonds has actually increased.”