Ring-fencing legislation to be implemented in the UK next year is credit positive for covered bonds of the country’s biggest banks, according to Moody’s, as the rules decrease the likelihood of bank failure, and covered bonds’ inclusion in the ring-fenced entities offers bail-in benefits.

From 1 January 2019 UK banking groups with more than £25bn of core deposits will be required to separate their core retail and SME operations from their investment banking operations, as part of a legislative effort to increase the stability of the UK banking system and make banking groups easier to resolve.

Four covered bond issuers will be affected by the rules, namely RBS, Lloyds Bank, Barclays Bank and Santander UK. According to Moody’s, each has proposed to include covered bonds in the ring-fenced banks, given that covered bonds are a material source of funding for the mortgage loans that form a substantial part of their retail operations.

Lloyds Bank plc and Santander UK, which are already the issuers of their group’s covered bond programmes, will be the respective groups’ ring-fenced banks. The Royal Bank of Scotland plc and Barclays Bank plc have proposed that their existing covered bond programmes will be transferred to their respective ring-fenced banks.

In a report published yesterday (Wednesday), Moody’s said the ring-fenced banks structure will reduce the likelihood of bank failure and, as a consequence, the likelihood that banks will cease making payments under the covered bonds.

The rating agency expects the credit profiles of ring-fenced banks to be in line with or stronger than the banks’ current credit profiles, reflecting their simplified and less diversified business models.

“The credit strength of issuers is a key driver of covered bond credit quality and the main trigger for declines in covered bond credit quality that have occurred to date has been a deterioration in issuer credit strength,” said Julie Ng, assistant vice president and analyst at Moody’s.

“Ring-fenced banks will in general be less likely than existing banks to suffer a decline in credit strength, given their less complex business models, which means there is less likelihood that the credit quality of covered bonds will deteriorate.”

Ng added that covered bonds issued by ring-fenced banks will also benefit from the credit positive effect of their high ranking in the bank’s liability structure in the event of resolution via bail-in.

“Bail-in rules, implemented by the UK pursuant to the EU Bank Recovery & Resolution Directive (BRRD), exclude covered bonds from absorbing any losses by way of bail-in in the event that the bank supporting the bonds enters resolution.

“Whilst the creditors of ring-fenced banks will likely have access to less bail-in-able capital to absorb losses (given ring fenced-banks’ low-risk business models), covered bond holders’ protection from bail-in will limit their exposure to bank defaults and losses in resolution.”