Recent regulatory developments are positive for planned Italian dual recourse instruments backed by SME loans, according to Moody’s and Fitch, as the new-style bonds will now likely be exempt from bail-in, but differences from OBGs could lead to divergent rating approaches.

The new instruments – which have previously been referred to as obbligazioni bancarie collateralizzate (OBCs) – will reflect typical covered bond characteristics but can be backed by assets that carry a higher credit risk than the mortgage or public sector loans permitted in Italian covered bonds obbligazioni bancarie garantite (OBGs).

The instruments match an on-balance sheet model proposed by the European Covered Bond Council in its European Secured Notes (ESN) initiative.

Moody’s in a report published on Tuesday of last week (28 June) – which echoed an earlier report by Fitch – said the new asset class will likely have access to preferential regulatory treatment under EU law, thanks to the implementation in April of a law giving the Bank of Italy power to adopt supervisory regulations for OBC. The Bank of Italy also fulfils this role for OBGs.

Moody’s noted this means the new instrument will likely qualify for “public supervision” – one of the conditions for an instrument to be categorised as a covered bond under Article 52(4) of the UCITS Directive. Instruments that meet the conditions of Article 52(4) are exempt from bail-in under the EU’s Bank Recovery & Resolution Directive (BRRD).

“We understand that OBC, alongside OBG, will be covered by this exemption and the broader safeguards afforded to covered bonds in a resolution scenario of the issuing bank under the Italian law implementing the BRRD,” said Moody’s. “This would reduce the exposure of OBC to bank defaults and losses, as it is the case with OBG.”

The initial legislation that introduced the new instrument – an amendment to Italy’s securitisation law in 2014 – did not address the issue of supervision, which Moody’s said had left scope for uncertainty over their regulatory treatment. Moody’s said the regulatory changes now suggest a higher level of systemic support for the instrument than it originally envisaged.

However, the rating agency noted that the legal framework for the new instrument remains incomplete, with secondary legislation still awaited from the Italian ministry of finance.

Moody’s noted these implementing regulations will prescribe the minimum overcollateralisation (OC) level applicable to the new bonds, the required characteristics of the guarantee benefitting bondholders and those of the assets eligible for inclusion in the cover pool, as well as the rules governing the issuance of the instrument, differentiating them from OBGs.

The rating agency said the legal framework, as well as structural features implemented by issuers such as OC and conditional pass-through maturities, will determine the risk profile of the bonds.

Moody’s said it will assess the new instrument using its covered bond rating approach. It said its Timely Payment Indicators (TPIs) will incorporate its views as to the strength of both the legal treatment and the structural features applicable to the bonds.

“The riskier nature of the assets backing OBC would not, of itself, constrain the average TPI of OBC to a lower level than that of OBG,” it said. “Provided that effective structural mitigants are in place and assuming the final legal framework for OBC is in line with the rules currently applicable to OBG, the new collateralised bonds may be assigned a TPI at the same level as traditional Italian covered bonds.”

In a comment published on 9 June, Fitch said the possible UCITs-compliance and bail-in exemption of the new-style bonds could allow it to assign resolution-related uplift over the issuer’s Issuer Default Rating (IDR).

However, Fitch said that other elements of its analysis point to differences between OBG and such “collateralised bank bonds” that would determine the final rating.

The rating agency said that the cover assets in a collateralised bank bond would probably have a shorter weighted average life than those in OBG secured by residential mortgages, limiting asset-liability maturity mismatches, but noted that these shorter-dated cover assets are less tradeable than mortgages.

It said that a collateralised bank bond with a soft bullet redemption profile and a maturity extension of up to 15 months may therefore not achieve the same notching differential as a OBGs rated by Fitch, which typically have this structure.

Fitch said refinancing risk would be lower in CPT structures and expected credit losses would be the major driver of breakeven OC levels, and said it would analyse credit risk in SME cover pools using criteria applicable to Italian SME collateralised loan obligations (CLOs).

“Performance of Fitch-rated SME CLOs suggests that credit risk would be higher for collateralised bank bonds backed by SME loans,” Fitch said. “The average ‘B’ portfolio loss rate for a residential OBG is 1.7%, compared with a 6.6% base case loss in SME CLOs – around 33% of the securitised portfolio includes unsecured loans.

“This would mean higher breakeven OC for the same rating level, or limit the overall rating.”