David Green: A plethora of new credit ratings

I have written before about how the introduction of investor bail-ins and the outlawing of taxpayer bailouts are likely to result in multiple credit rating downgrades at UK and other EU banks. Ratings are likely to change – up or down – for another reason too.

As well as bail-in, the recent legislative changes have reordered the priority of creditors at banks, meaning that a single long-term credit rating is no longer appropriate. Your chance of suffering a loss depends partly on how much money ranks below you in the pecking order – this used to be the same for the individual savings account of £5,000, the medium sized company with £250,000 and the local authority deposit of £2m, as well as the cleaning contractor expecting his £20,000 bill to be paid.  Until recently, all four of these were described as senior unsecured creditors. Now they all rank differently, meaning that the likelihood of default and the likely loss given default are different, and so having separate credit ratings for each now seems appropriate.

Moody’s is the only major rating agency to have released plans to revise its credit rating methodology for banks, so far. Their starting point will be the same as it is now, the baseline credit assessment (BCA). This considers a bank’s operating environment, financial health and management competency, and is expressed on the familiar Aaa to C scale, but with a lower case initial, e.g. Barclays Bank has a BCA of baa2.

The BCA can then be uplifted for what Moody’s terms “affiliate support”, such as the likelihood of recapitalisation by a parent company, to give an adjusted BCA. This currently maps directly to the bank financial strength rating (BFSR) on the A to E scale which you may be familiar with; Barclays BFSR, for example, is C-.  If your treasury management strategy still sets a minimum criteria for BFSRs, you should note that Moody’s intends to withdraw these later this year.

In a new move, Moody’s plans to notch the adjusted BCA up or down, depending on where in the creditor priority the specific investment class sits. The direction and size of this notching will depend on the amount of money below you in the hierarchy which will absorb losses first, and also on the amount of money ranking equal to you, which you will share the losses with. This will result in a preliminary rating assessment (PRA). As a purely illustrative example, local authority deposits at Barclays could get a one notch uplift to Baa1, medium-sized corporate deposits two notches uplift to A3 and small individual deposits three notches up to A2.

Finally, in exceptional circumstances, Moody’s may award an additional uplift to the PRA for potential government support. This is expected to be rare, given that bailouts have been outlawed by legislation until after investor bail-ins, although Moody’s knows that there remains a possibility of governments bending the rules when it suits them. So Royal Bank of Scotland’s ratings could receive a small uplift, given it remains in majority public ownership, but this is unlikely for other banks.

These new credit ratings will need new names to differentiate them from each other.  Moody’s has coined the term “junior deposits” to refer to local authority and similar ranking investments. The two ranks above may be called “eligible” and “covered” deposits, if they adopt the terminology used in the EU directives.

Moody’s is adopting a slightly different methodology to measure the credit risk of the bank’s operational creditors, such as our cleaning contractor whose invoice is exempt from bail-in. This will be expressed as a “counterparty risk” rating, on the usual Aaa to C scale, but with a “cr” suffix, such as A3(cr). In the EU, we expect this to be set above the junior deposit rating, and similar to the rating for covered or eligible deposits.  This is because it will be notched from the adjusted BCA in a similar fashion, taking account of lower ranking creditors that can be bailed in, plus any potential government support.

Local authorities will need to be careful not to use this new counterparty risk rating when making investment decisions, but to look at the rating for the relevant investment class instead – be that a junior deposit, a covered bond, or a senior unsecured bond.  These changes, and any similar ones that may be announced by Fitch and Standard & Poor’s, may also require changes to the wording in authorities’ treasury management strategies.

Furthermore, it calls into question the recommendations in the various governments’ guidance on local authority investments in England, Wales and Northern Ireland. These require “specified investments” to be made a body or scheme of high credit quality. But as the credit quality of the actual investment type becomes more removed from the counterparty credit rating, the specified investment definition will become even less relevant than before.

David Green is Client Director at Arlingclose Limited. This is the writer’s personal opinion and does not constitute investment advice.