DBRS Publishes Updated EU Covered Bond Methodology

DBRS Ratings Limited (DBRS) has today published its updated “Rating European Covered Bonds” methodology (the Methodology).

The Methodology update follows the conclusion of the Request for Comment period on 26 June 2015. DBRS did not receive any comment to the proposed methodology; however, DBRS is aware of at least two instances of external market commentaries which suggested that further clarifications of some of the qualitative factors included in this analysis are advisable. These commentaries also pointed to potential rating volatility, which may emerge because of the use of the Senior Unsecured Rating (SUR) of the Reference Entity (RE) as the basis of the Covered Bonds Attachment Point (CBAP) during the course of the RE’s resolution.

In response, DBRS clarifies in the final version of the methodology that, in the immediate aftermath of a successful resolution where the bail-in tool is applied and the CB programme in its entirety remains with the going-concern part of the RE in resolution, DBRS expects that the CBAP would decouple from the SUR. Moreover, DBRS explains the analytical considerations involving qualitative factors in the CBAP analysis in further detail in Appendix B of the Methodology. At the same time, DBRS has separately published its current assessment of those jurisdictions for which Covered Bonds (CB) are deemed to be a particularly important funding instrument (see comment available at www.dbrs.com).

The market value spread assumptions are available under a separate addendum to the Methodology and are not being republished at this stage.

The Methodology, effective today, supersedes the previous “Rating European Covered Bonds” published in December 2014. The updates to the Methodology constitute a material change to the previous version.

DBRS refines its analysis for deriving the CBAP of all European CB programmes that have a RE that is subject to the Bank Recovery and Resolution Directive, enacted on 15 May 2014, or an equivalent regime. The new method involves the use of the RE’s SUR (RE-SUR) as a reference rating for the CBAP and the possibility of notching up to one or two notches above that reference in certain circumstances. The level of notching will depend on DBRS’s assessment of two main factors: (i) the importance of the RE for the economic and financial system of the relevant country and (ii) the importance of the CB as an instrument for the economic and financial system of the relevant country and for the core business of the RE. The CBAP is one of the building blocks of the Methodology and represents the likelihood that the RE will keep meeting timely payments on the CB before the source of payment switches to the Cover Pool. The CBAP is currently tied to the issuer rating of the RE in Europe. The issuer ratings in Europe are currently the RE-SURs and are at the same level as the RE’s deposit ratings.

In the immediate aftermath of a successful resolution, in cases where the bail-in tool were applied and the CB programme in its entirety were to remain with the going-concern part of the RE in resolution, DBRS expects that the CBAP would decouple from the SUR . At that point, the CBAP will be set at a level that DBRS considers consistent with the ability of the new RE to continue to be the source of payments for the CBs. This takes into account any possible guarantee or operational support, and can be in the investment grade category if circumstances warrant. The CBAP determination also considers the rating of the sovereign.

At the same time, DBRS has today published a press release announcing its intention to introduce a Preferred Obligations Rating for the European banks that it rates. This rating will cover obligations/ exposures at certain banks where DBRS considers that the instruments have a higher probability of remaining in a going-concern entity at the point of resolution of the broader entity.

DBRS considers that the analytical reasoning behind the Preferred Obligations Ratings is similar to the one underpinning the determination of the CBAP. To the extent that the Preferred Obligations Ratings are introduced, it is likely that they will provide the starting point for the CB analysis.

DBRS expects the net impact of the updates to the Methodology to have a positive to neutral effect on all European CBs it rates; however, following a rating action on 20 May 2015, the ratings of ten out of 15 REs that DBRS publicly rates were placed or maintained Under Review with Negative Implications because of a review of the treatment of Systemic Support in DBRS Financial Institution rating analysis. As a result, both the direction and the size of the combined impact is uncertain; however, DBRS expects that, for the large majority of CB programmes, the net effect would be neutral.

DBRS intends to take rating actions for the CB Programmes of those RE whose issuer rating does not currently have any notching benefit from sovereign support in the near term. It is possible that these CB ratings might be subject to further rating actions if the intention of DBRS to introduce Preferred Obligations Ratings eventually materializes; however, DBRS deems the rating actions to be unlikely. For CBs issued by an RE whose issuer rating currently incorporates a notching benefit from sovereign support, DBRS expects that it will not be able to take conclusive rating actions before, at a minimum, the review of the issuer rating is concluded. Should the intention to introduce Preferred Obligations Ratings eventually materialize, this may further delay the conclusion of the review on the CB ratings.

Notes:
The methodology providing DBRS's processes and criteria is available by contacting us at info@dbrs.com.

DBRS criteria and methodologies are publicly available at www.dbrs.com under Methodologies.

For more information on this credit or on this industry, visit www.dbrs.com or contact us at info@dbrs.com.