Fitch Ratings says the European Council and European Parliament bank recovery and resolution directive (BRRD) proposals will not, in the short term, lead to a change in Fitch's methodology for covered bonds. This is because the directive is still at a draft stage, further negotiations on the proposals are scheduled to take place and there is likely to be an element of discretion for national resolution authorities on how to implement bail-in measures. Although positive for covered bondholders as these securities are currently explicitly excluded in the proposals from the scope of the directive's bail-in tool, other aspects of the protection currently enjoyed by investors are left unclear, such as the treatment of voluntary over-collateralisation above the mandatory minimum.
Unlike covered bonds, it is proposed that banks' senior unsecured debt will technically be eligible for bail-in if conditions for resolution are met and early intervention measures or the write down of junior debt has proven insufficient to restore viability. This effect could in theory widen the difference between the covered bonds rating and the senior unsecured debt rating of a given European institution.
However, this consideration does not, strictly speaking, apply to Fitch's covered bonds criteria, as our starting point for their analysis rests on the relevant Issuer Default Rating (IDR) rather than the institution's senior unsecured debt rating. Contrary to the senior unsecured debt rating, which also incorporates expectation of recoveries given default, the IDR indicates an entity's vulnerability to default, and is therefore independent from the level of recovery given default achieved on a specific debt class.
Fitch continues to believe that the IDR is an appropriate reference for covered bond ratings given the first recourse of bondholders to a financial institution. The agency recognises that banks can default in several ways, many of which would not lead to the cover pool taking over the issuers' obligation towards covered bonds investors. Arguably, a liquidation scenario - which would definitely cause the cover pool to be split from the bankruptcy estate of an issuer - is becoming a less likely form of default to occur thanks to the resolution tools proposed in the BRRD, several of which are already at authorities' disposal in certain EU countries. However, the nature of a bank default is not foreseeable in advance, especially when the institution is well rated and its likelihood to default low. Therefore the agency deems the IDR to be the most reasonable proxy at this stage, but may depart from this convention once there is greater visibility of the type of default an institution is likely to suffer.
As a case in point, in the recent events in Cyprus, Fitch no longer used the IDR as the starting point for the covered bond risk assessment in Cypriot banks. In late March 2013 uninsured depositors were bailed-in alongside other junior creditors and capital controls were imposed. Cypriot banks' IDRs were downgraded either to 'Restricted Default' (RD) or to 'Default' (D) to reflect an uncured payment default on obligations other than covered bonds. Cypriot banks' covered bond ratings were subsequently downgraded to 'B' from 'B+' and at the country ceiling rating cap, based on the view that material credit risk arose. The agency also viewed that it was unlikely that the covered bonds would suffer a default in the short-term, mainly as a result of established liquidity provisions and because these instruments were not expressly included in bail-in.
Future European bank resolution is likely to be bespoke in nature, limiting the ability to develop strict criteria at this time. Fitch will continue to monitor developments of the European bank resolution regime, and comment on any impact on banks' or covered bonds rating in due course.
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