Moody’s Investors Service is proposing revisions to its methodology for rating banks to reflect the impact of the financial crisis, and the changes the crisis has wrought on the industry and bank regulation.
The rating agency says that the changes aim to “provide a new framework for determining how each type of creditor is likely to be affected when a bank needs to be resolved, and to help more precisely predict bank failures.” It is seeking feedback on its proposed methodology by November 7.
“The dramatic shift in public policy in recent years favouring ‘resolution regimes’ highlights the importance for investors of their position in a bank’s liability structure and the potential losses they are exposed to in the event of resolution,” says Moody’s.
As a result, Moody’s is proposing to introduce a “loss given failure” analysis to its ratings process. “This would provide a superior framework for determining how each type of creditor is likely to be affected when a bank needs to be ‘resolved’ and would explicitly incorporate the benefit each creditor class derives from the amount of debt subordinate to it and which thus protects it from loss,” it says; adding that this change would be the main driver of any ratings changes arising from the new methodology.
For banks that are likely to be resolved through bail-out, bankruptcy, or ad-hoc resolution, Moody’s says that it will preserve its existing notching practices based on the type of instrument. Beyond this, Moody’s says its revised methodology aims to provide an “enhanced and more transparent” framework for analyzing a bank’s stand alone strength through its baseline credit assessment (BCA), “reflecting the insights gained from the crisis and more recent banking sector distress.”
Moody’s says that if it implements the changes as proposed, the impact on ratings will be greatest in the European Union (EU) and North America, “where resolution and recovery techniques would lead to greater discrimination across the capital structure”. It estimates that, globally, local currency deposit ratings could rise by about half a notch on average, with 34% being upgraded and 7% downgraded. For local currency senior unsecured debt ratings, it estimates they could rise an average 0.2 notches, driven by upgrades of 30% of senior unsecured ratings, and downgrades of 21% of ratings.
“Deposit ratings would in some cases move higher than senior unsecured debt ratings, which would be positively affected in Europe but negatively in the U.S., due to differences in liability structures and likely deposit preference,” it says.
Additionally, Moody’s is considering revisions to its systemic support assumptions for European banks. “While the timing and outcome of this re-assessment of systemic support is still uncertain, hypothetical scenarios reflecting reduced systemic support in the EU, combined with the impact of the proposed methodology, would leave deposit ratings in the region slightly higher, on average, but senior unsecured ratings broadly unchanged or lower,” it says.
Moody’s estimates that 95% of BCAs would remain unchanged, with just 1% falling by one notch and 4% rising by one notch or more.