Tier 2 under threat from Fitch draft, AT1 set for boost

Fitch’s ratings of Tier 2 debt could be cut by one notch under proposed new rating criteria released in a report on 15 November, although AT1 instruments could be lifted one notch.

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The report, “Exposure Draft: Bank Rating Criteria”, specifies Fitch Ratings’ methodology for assigning new ratings to banks and monitoring existing ratings. Fitch’s proposed rating framework for banks is largely consistent with previous criteria with respect to the core VR and Support Rating aspects of the framework.

The most material changes proposed relate to notching applied to senior and subordinated (AT1 and Tier 2) unsecured debt:

●  Fitch proposes a more forward-looking approach to determining when to notch up a senior debt rating, Derivative Counterparty Rating (DCR) and/or deposit rating:

o  Based on resolution plan and forward-looking issuance expectations — of note, no timeframe on forward-looking horizon provided by Fitch

•  For reference, Moody’s takes MREL/TLAC issuance plans/targets up to three years in advance (base case two years), while S&P has a two year forward-looking horizon

o  Threshold for upgrade revised to a generic 10% of RWA — this replaces current framework of Fitch calculating individual recapitalization amounts on a per bank basis

•  10% of RWA = approximation of 8% P1 + generic 2% P2R assumption (CACIB view)

o  For jurisdictions with general deposit preference (e.g. Portugal, Italy, Greece, Cyprus, Bulgaria, Romania, etc), Fitch will notch down senior (preferred) debt from the IDR (= VR + support, if any), to take into account situations where:

•  “debt buffers are thin or resolution debt buffers are likely to include more senior liabilities”

●  Tier 2 debt notching (banks with VR of bbb- or above):

o  Currently Tier 2 debt is notched down one notch from the relevant rating anchor (typically the VR in the EU + UK)

o  Future proposed method: notch down twice from the relevant rating anchor (same approach as S&P; Moody’s rates Tier 2 debt based on LGF outcome)

●  AT1 debt notching (banks with VR of bbb- or above):

o  Currently AT1 debt is notched down five notches from the relevant rating anchor (typically the VR in the EU + UK)

o  Future proposed method: four notches down from the relevant rating anchor (same approach as S&P; Moody’s typically three notches down)

•  Of note, this is the base case notching for AT1 by Fitch. It remains to be seen whether additional notches will be applied for cases with heightened non-performance risk (e.g. risk of coupon reduction or cancellation due to low ADI or MDA)

●  Additionally, Fitch suggests it can factor sovereign support more routinely into junior debt of banks with IDRs that are driven by sovereign support

●  Fitch also proposes a new approach for its core capitalization metric. Where disclosed, Fitch proposes to use the regulatory Common Equity Tier 1 ratio instead of its existing approach based on Fitch Core Capital. If fully-loaded CET1 ratios are disclosed, this is the measure that Fitch intends to take, otherwise transitional CET1 ratios will be applied

Fitch is currently gathering market feedback until 31 December, after which it will consider the feedback and finalise the criteria. During the exposure draft period, it will apply the existing criteria to existing ratings, but will already apply the criteria described in the exposure draft to new rating assignments. We expect the finalisation to occur in 1H20.

With the base case Tier 2 notching of -2 (from -1), some banks’ Tier 2 ratings are more at risk of falling into sub-investment grade category and losing index eligibility. UniCredit Tier 2 bonds (Baa3 Stable/BB+ Stable/BBB- Negative) may be vulnerable to falling back to sub-IG if downgraded by Fitch. This is after they received index eligibility on 18 July when Moody’s upgraded its Tier 2 rating to IG. Tier 2 bonds from CaixaBank, Commerzbank and Aareal Bank could also be vulnerable because of the review, still remaining IG, but closer to sub-IG territory.

With the base case AT1 notching of -4 (from -5), notable beneficiaries include Lloyds (Baa3/BB-/BB+) and Nationwide (Baa3/BB+/BB+), with a Fitch upgrade resulting in two out of the three ratings being IG.

Please see table with more details of Fitch’s proposals and their potential direct rating impact in the pdf of this article here.