Moody’s: AT1 o’clock

Moody’s methodology for rating hybrid securities has evolved with the development of post-crisis, Basel III-compliant instruments, most recently with the publication of a Request for Comment on “high trigger” CoCos in May. Barbara Havlicek, senior vice president, team leader, hybrid capital group, at Moody’s, explains the rating agency’s thinking.

Moody’s has recently proposed an update to its bank hybrid rating methodology. What is the scope of this proposal?

Our proposed methodology will allow us to rate the whole universe of contingent capital securities where equity conversion/principal write-down is triggered by regulatory discretion and/or the breach of regulatory capital triggers.

The proposal specifically outlines our approach to the following:

• A framework for rating “high trigger” contingent capital securities that includes a conversion/write-down trigger designed to trip well in advance of a bank’s point of non-viability or failure.
• Revisions to our existing framework for rating non-viability contingent capital securities, where conversion/write-down is triggered at or close to the point of non-viability or failure.

How has Moody’s thinking evolved over the past years regarding the rating of bank capital securities?

The universe of bank contingent capital securities currently consists of non-viability securities (where losses are imposed at or close to the point of non-viability) and “high trigger” securities (where losses are imposed well in advance of the point of non-viability). In February 2010, when the market was in its infancy, we established a moratorium on rating contingent capital securities that have conversion/write-down triggered by regulatory discretion and/or the breach of regulatory capital triggers.

Our decision reflected the difficulty of predicting when an impairment event would be triggered given the limited performance history of such securities, the rapid innovation of structures, associated lack of a developed market, and the evolving regulatory and political environments. These factors all influenced when contingent capital securities could possibly absorb losses as a bank’s financial condition deteriorates.

Since that time, regulatory and political willingness to impose losses on bank creditors — particularly junior creditors, in advance of, and as a means to limit public sector support — has become more firmly entrenched, both in practice and in our bank rating considerations. These market developments have helped us gain comfort that an impairment event for a non-viability contingent capital security would be triggered at a point close to when junior bank securities that we currently rate are taking losses. Consequently, we are more comfortable using the analytical tool we already have in place — our Baseline Credit Assessment (BCA), which measures the bank’s standalone financial strength and is a proxy for the point of non-viability, as the starting point for rating non-viability securities.

As a result, in May 2013, we introduced a framework to rate non-viability securities in an update to our Global Bank Rating Methodology. However, we continued our moratorium on rating “high trigger” securities because they required analytical tools beyond the scope of our BCA to capture the additional risk of a trigger breach.

Since May 2013, we have continued working to develop the needed set of analytical tools to capture the additional risk of impairment resulting from a trigger breach for “high trigger” securities, beyond determining the probability of a bank-wide failure and coupon suspension. This is the proposal that we outlined in our Request for Comment that was published in early May.

What are the key challenges in rating “high trigger” bank capital securities?

The key challenge in rating “high trigger” securities is that they could behave in ways that are difficult to predict. While our model provides an analytical tool to capture the probability of a bank-wide failure and a trigger breach ahead of a bank-wide failure — both significant risks in rating these securities — there is the possibility that a regulator could intervene earlier than anticipated or that bank capital ratios fail to adequately capture the true financial health of the bank. As a result, similar to the way that we assign bank ratings generally, rating committees may use judgment to position ratings reflecting their assessment of the expected loss of the security.

Barbara Havlicek, Moody’s

Can you take us through the main steps when assigning ratings to bank capital securities? 

As mentioned previously, the contingent capital universe consists of non-viability securities (where equity conversion or principal write-down is triggered at or close to the point of non-viability) and “high trigger” securities (where equity conversion or principal write-down is triggered well in advance of the point of non-viability).

For rating non-viability securities — where we use our BCA as a proxy for the point of non-viability or bank-wide failure — we use a notching framework that is anchored from the Adjusted BCA (BCA plus parental and/or cooperative support, if any). For rating non-viability Tier 2 securities, our default position would remain Adjusted BCA less two notches to reflect the subordination of the instrument and the uncertain timing to the triggering of conversion/write-down. For Additional Tier 1 (AT1) securities, we are proposing to position the ratings three notches — rather than four notches as is our current practice — from the Adjusted BCA to reflect the higher probability of impairment associated with non-cumulative coupon suspension and to avoid double counting this risk with the probability of a bank-wide failure.

For rating “high trigger” securities, our framework uses a model-based approach that incorporates our view of the bank’s current financial strength as captured through its BCA and its last-reported Common Equity Tier 1 (CET1) capital ratio, potentially adjusted for our forward-looking view, to determine the probability of a trigger breach as well as the probability of a bank-wide failure.

The model measures the distance from the bank’s CET current capital ratio to the capital level set as the “trigger” for imposing losses on the security. It takes the probability of a bank-wide failure and adds to it the probability of trigger breach ahead of a bank-wide failure, which is then mapped to Moody’s four year idealised default tables. After factoring in loss severity, the model generates a rating that is the starting point for the rating discussion.

We will cap the “high trigger” security rating at the level of the non-viability security rating if the model-based rating outcome points to a “high trigger” security rating that is above the bank’s non-viability security rating. That is because a “high trigger” security rating is comprised of the credit risk of its non-viability component and that associated with the distance to trigger breach, which means the “high trigger” rating could never be above the non-viability security rating. The non-viability security rating also captures the risk of coupon suspension, if such a feature exists. Effectively, we are rating to the greatest risk among a trigger breach, non-viability, and impairment associated with coupon suspension.

Final positioning of the rating involves rating committee input to evaluate specific features that may prompt certain bank behaviours (for example, if a “high trigger” security has a full principal write-down, a bank may not have any qualms about allowing the trigger breach to occur because there is no associated equity dilution). Beyond the features of the specific security, we may also factor in other circumstances of a particular bank such as its ability to issue new equity or take other remedial actions such as deleveraging or selling off business units to avoid a trigger breach. We may also consider how close a bank is to breaching its capital buffers, which would result in coupon suspension as a first step once a bank starts to weaken financially.

Why does Moody’s believe that a model-based approach is needed to rate “high trigger” securities? What are the main assumptions factored into your model?

Simply stated, the absolute risk of a “high trigger” security is the distance to trigger breach, which is best captured through a model rather than through a simple notching-based approach. However, this distance only captures one aspect of these securities’ risks, the second being the risk of the security relative to the fundamental strength of the bank.

As a result, we tie our determination of the probability that the trigger will be breached to the bank’s BCA and cap the “high trigger” security rating at the non-viability security rating, which also captures the risk of coupon suspension, in our proposed rating approach. The end result is an analytical framework that incorporates the incremental credit risk of a trigger breach in a manner consistent with the overall credit assessment of the bank.

In our model, we assume that the distribution of a bank’s forward capital ratios follows a normal distribution. To create the distribution, the bank’s expected capital ratio is assumed to be the mean of the distribution of forward capital ratios. Our model inputs include the capital ratio trigger in the security itself, the bank’s expected capital ratios (which we may adjust based on our forward view of the bank’s capital), and its BCA.

How is your proposal reflecting the development of resolution frameworks (e.g. BRRD)? How can it affect the rating of bank capital instruments?

Our proposal captures the risk of contractual non-viability and “high trigger” securities, which may be subject to losses as a means to avoid a bank-wide resolution.

If implemented as currently proposed, what is the expected rating impact for outstanding bank capital securities i.e. AT1, legacy Tier 1 and Tier 2?

If the proposed changes are implemented, approximately 20, mostly Additional Tier 1 non-viability security ratings could be upgraded by one notch.

Does Moody’s differentiate among the various loss absorption mechanisms (temporary and full principal write-down, equity conversion)?

For the ratings of both Tier 2 and Additional Tier 1 non-viability securities, we do not distinguish the risk of a full principal write-down versus equity conversion or a partial/temporary principal write-down. That is because by the time a bank reaches the point of non-viability, the difference between these types of loss mechanisms would not likely warrant an additional notch. However, for the ratings of “high trigger” securities, we will add an additional notch for a full principal write-down to reflect the potential for greater loss severity relative to equity conversion or a partial/temporary principal write-down, unless the rating is already subject to the non-viability security rating cap.

What is the equity credit granted to Additional Tier 1 instruments? Is there any difference between high and low trigger instruments?

For Additional Tier 1 securities, we typically assign equity credit based on the features of the host security, whether there are high or low (non-viability) triggers. Generally speaking, these securities are assigned 75% equity credit.

Would the same criteria be applied to contingent capital securities issued by non-bank institutions, e.g. insurance companies?

Contingent capital issued by non-banks would be rated using the same analytical thought process proposed for banks. Specifically for insurers, we would determine the non-viability point based on each jurisdiction’s regulatory framework as well as factor in the probability of a trigger breach.