The ECBC has welcomed a Moody’s proposal to modify the anchor point for covered bond ratings given a new bail-in regime, but called on the rating agency to go further, for example to increase the potential maximum uplift and relax its expected loss assumptions.

ECBC offices, Brussels

Moody’s on 19 September opened a consultation to change the issuer anchor point for covered bond ratings given that bank senior unsecured debt, the rating of which has hitherto been the anchor point, will be subject to bail-in under a new EU framework while covered bonds will be exempt from burden-sharing (a similar regime is expected to apply in Norway). Market participants had until Monday to comment, with the European Covered Bond Council (ECBC) releasing its response on the deadline day.

“We believe that the proposed methodology change is an important step in the right direction,” said the industry body, “acknowledging the preferential treatment of covered bonds relative to senior unsecured debt under the upcoming EU bail-in and resolution regime.”

It said that the proposed criteria were “thoroughly discussed” within the ECBC rating agency approaches working group, chaired by Boudewijn Dierick, head of flow ABS and covered bond structuring at BNP Paribas.

Although it welcomed Moody’s initiative and proposal, the ECBC also made a mix of criticisms and recommendations in the context of general feedback as well as in responses to specific questions raised by the rating agency. An overarching comment was the need for greater clarification on several aspects of the proposal so that issuers can better assess the impact of the proposed changes.

Others included a recommendation that Moody’s take into account a second potential exemption for covered bonds in the EU bank resolution directive, which gives EU Member States the right to also exempt covered bondholders’ residual claims on the issuer’s bankruptcy estate from bail-in.

“Our understanding is that this second exemption was not taken into consideration by Moody’s in this RFC which applies to the minimal case,” said the ECBC. “Thus, should a Member State grant its national issuers this additional layer of protection, we invite Moody’s to take this into account.”

Another point made by the ECBC was that Moody’s should revise its expected loss (EL) assumptions for covered bond collateral to reflect future regulatory developments.

“For instance, single resolution and supervisory mechanisms for the Banking Union that are put in place within the EU will certainly increase the number of potential buyers of cover assets incorporating, in addition to purely domestic market participants, all banks within Europe,” said the ECBC. “Hence, the liquidity of cover pool assets should be re-evaluated to incorporate the benefits of a centrally regulated EU Banking Union.”

The ECBC also said that some of its members, while recognising the benefits of Moody’s proposed approach, have stressed that covered bond ratings should “ideally not be linked to an element which would be directly impacted in case of bail-in” as this would risk the covered bond rating being dragged down should senior unsecured debt be bailed-in.

“Therefore, we invite Moody’s to clarify its view on how the covered bond rating would behave throughout the bail-in based on the new anchor points if the ratio of bail-inable debt to total liabilities breaches one of the thresholds due to the bail-in of senior unsecured debt,” it said.

Moody’s has proposed a maximum two notch uplift over the adjusted BCA and one notch above the SUR, but the ECBC said that this uplift is too limited.

“The issuer rating can easily drop to the single-B area if the issuer is in trouble, dragging down the covered bond rating to levels which, in our view, do not properly reflect the quality of the covered bond product and the willingness of governments to support this asset class,” it said.

The potential uplift from the BCA will depend on the amount of bail-inable debt, with two notches of uplift available where an issuer has an unsecured senior and subordinated debt/total liability ratio of 10% or higher, one notch for 5%-10%, and no uplift when the ratio is less than 5%.

According to the ECBC, Moody’s proposal “missed the inflexion point” set out in the EU bail-in directive, which it notes allows for the use of public restructuring funds in some countries to absorb any losses in excess of 8% of liabilities.

“Moody’s should take into consideration this possibility because in these countries, issuers might cap their bail-inable debt/total liabilities ratio at 8% and these issuers should not be penalised for not reaching the upper threshold (in the current proposal, the ratio must be greater than 10% in order to get two additional notches),” said the ECBC. “The maximum uplift should be given as soon as the level beyond which the resolution fund is set up is achieved.

“In addition, any excess bail-inable debt or liabilities compared to the threshold of national resolution funds should be interpreted as allowing for a reduction of the probability of issuer default and should be taken into account in Moody’s EL level and OC requirements.”

The industry body also noted that the bail-in regime should have a beneficial impact on covered bonds not currently rated at the sovereign ceiling or Aaa, which Moody’s proposal suggested will not be affected.

“However, given the fact that the bail-in will reduce the likelihood of issuer default, it makes sense that this new methodology has an impact on Aaa issuers, including a reduction in overcollateralisation requirement,” said the ECBC.

It also noted that the rating impact could be greater than that outlined by Moody’s given that most covered bond programmes have rating triggers linked to Moody’s SUR ratings, for example for swap termination.

“Those programmes that are close to the point where replacement language applies could find that, notwithstanding the fact that the new approach still allows a theoretical Aaa rating, if bail-in leads to drops in SUR of sufficient banks, such wholesale replacement of swaps/bank accounts might not be feasible across the market and this may have greater impact than envisaged in the ‘rating impact’ paragraph of the RFC,” according to the ECBC.

The ECBC’s response can be found in its entirety here.