Scope’s highlights that both Additional Tier 1 (AT1) and Tier 2 (T2) securities issued by banks under the new regulatory framework (CRD 4-CRR in the EU) are subject to principal loss absorption risks and that in addition AT1 securities are exposed to coupon cancellation risks as well. These risks are incorporated into the finalized rating methodology for bank capital instruments which the rating agency has just released. The final methodology took into account market comments and other feedback following the publication of the initial “request for comments” draft in July.

AT1 securities carry both coupon cancellation and principal loss absorption risks
Scope said that it intends to notch down from the issuer credit-strength rating (ICSR) at least two notches for the inherent coupon cancellation risks and at least another two notches for the inherent principal loss absorption risks. The notching-down is based on the rating agency’s consideration that on the one hand the likelihood of coupon cancellation is materially less remote than the likelihood of principal conversion or write-down. On the other hand, the magnitude of loss stemming from principal conversion or write-down is materially higher than from missed coupon payments. The methodology notes that these are two distinct risks for AT1 investors and reflects this in separate notching gaps.

Reasons for further rating notching beyond the minimum four
Scope also highlights the likelihood of additional notching down – beyond the minimum of four notches – due to either security-specific or issuer-specific considerations. While identifying several such factors in its methodology – the distance to trigger level and to the combined buffer requirement, the status of the issuer within the group, the issuer’s liability and capital structure, regulatory trends, etc. – the rating agency cautions that others may be added as the market for bank AT1 securities is relatively new and continues to evolve.

Scope added that there would be a wider rating notching as coupon cancellation and principal loss absorption risks increase, which would particularly be the case with less financially strong banks (with ICSRs in the BBB range and below).

Pauline Lambert, senior bank analyst at Scope and author of the methodology, noted that “due to the dynamic nature of capital requirements and the restrictions placed on coupon payments when certain capital requirements are not met, ratings on AT1 instruments are likely to be more subject to change than for other securities of the same issuer, such as senior unsecured debt or even T2 securities.”

No automatic downgrade for one-off coupon cancellation
In the event that an issuer does not pay AT1 coupons or pays only a partial coupon – which is allowed by regulations – Scope intends to evaluate the reasons for the missed payment. If this is a one-off event which does not impair the bank’s future capacity to make distributions, the AT1 security rating may not be changed (specifically such an event may not be considered a distressed debt exchange or a default). If, however, the reason for coupon cancellation is due to negative credit developments related to the issuer, the downgrade of the ICSR and also possibly a concomitant widening of the notching gap for the AT1 security are very likely.

In the event of principal conversion or write-down, investors would have experienced a material loss on their investment. And while the terms of the AT1 security may state that this is not a default, Scope would consider this to be materially similar to a default.

At least one notch down for T2 securities
In its methodology, Scope noted that investors in standard T2 securities are exposed to principal loss absorption risks but not to coupon cancellation risks. T2 securities also rank above AT1 in insolvency and bail-in and do not require a trigger for write-down or conversion (although several banks have issued T2 securities with triggers). As a consequence, T2 investors benefit from the capacity of AT1 securities to recapitalize a bank in difficulty.

For financially stronger banks (with ICSRs in the A to AAA range) Scope considers that the risk of being written down or converted at the point of non-viability (PONV) is materially very low and therefore standard T2 securities are in essence regular subordinated debt. Accordingly, when rating specific T2 securities Scope will assign at least one notch down from the ICSR to reflect their junior status. However, for financially less strong banks (with ICSRs in the BBB range and below) the risk of write-down or conversion at the PONV is marginally less remote, justifying wider notching down.
“Bank capital instruments rating methodology”, which can be accessed at www.scoperatings.com, complements Scope’s two previously published methodologies related to bank ratings, namely “Bank rating methodology” (February 2014) and “Forecasting bank financials methodology” (February 2014).

Download the complete methodology here