The credit risk of minor banks’ covered bonds can be higher as a result of EU MREL requirements, Moody’s has warned, since they are more likely to remain with an insolvent entity than a going concern, with their fate potentially depending on whether they are considered a “critical function”.

In research published today (Thursday), Moody’s noted that regulators are in the process of determining for banks their requirements under the minimum requirement for own funds and eligible liabilities (MREL) and formulating/approving recovery and resolution plans under the Bank Recovery & Resolution Directive (BRRD), with MREL being phased in over the next four years.

According to Moody’s, minor banks – smaller and less systemic banks that do not carry out “critical functions” – may lack sufficient importance to be resolved as going concerns, and it said that MREL requirements that only target a bank’s capital needs for insolvent liquidation could increase the chance that a bank’s covered bonds remain in an insolvent entity – increasing the risk of losses.

Meanwhile, covered bonds might not be considered a “critical function” – functions determined to be those most likely to be kept alive should a bank fail, and which MREL resources may therefore be allocated to.

“Certain considerations may lead EU resolution authorities to recognise covered bonds as a critical function even for smaller and less systemic banks,” said Jane Soldera, vice president and senior credit officer at Moody’s. “However, there is currently little publicly available information to support this.

“Even if covered bonds are considered critical functions for individual institutions,” she added, “this classification is unlikely to be transparent to bondholders.”

Moody’s noted that European Banking Authority draft regulatory technical standards (RTS) published in July 2015 assume that, as a first option, failing minor banks could be placed fully, or for the most part, into insolvent liquidation – subject to the caveat that this is “feasible and credible”.

“The authorities give little guidance on what is feasible and credible, but the indications from both the RTS and the United Kingdom’s proposed policy on MREL are that a bank’s size and its level of critical functions will be key considerations,” it said. “The larger an institution, the more likely it is to carry out a greater number of critical functions.”

However, Moody’s noted that the size of an institution may belie its importance for certain functions and that EU regulators will not necessarily take a resolution approach based mainly on size.

The rating agency cited several factors that could improve the likelihood of covered bonds being considered among critical functions – such as their resilience and exemption from bail-in under BRRD – but noted that in an EBA sample of 12 banks’ resolution plans none specifically mentioned covered bonds, even if 11 identified retail lending (including mortgages) as a critical function. Bank of England proposals also do not specifically contemplate covered bonds as a critical function.

The fate of covered bonds issued by specialist mortgage credit institutions that do not take deposits can be different, Moody’s noted, given that there is an exemption for such institutions under BRRD.

“The exemption reduces the connection between MREL, resolution strategy and outcomes for covered bonds in the case of specialist mortgage credit institutions,” said the rating agency. “This creates flexibility to implement resolution-type procedures tailored to the needs of those institutions.

“Regulators of specialist mortgage credit institutions are likely to consider the institutions’ role in supporting mortgage lending and the potential systemic risks to the covered bond market if an issuer fails (the market may be important domestically, such as in Denmark),” it added. “Covered bond issuance may be critical to these institutions, and if the country wishes to protect this market or issuance model, regulators will be incentivised to avoid letting the failure of an institution undermine the covered bond market.”