Scope Ratings today published its first covered bond rating methodology and calls for comments from market participants by 3 April 2015. The proposed methodology reflects the enhanced credit protection available to covered bonds compared with other debt issuances of financial institutions, following the implementation of the European resolution and recovery directive (BRRD) and similar regimes in other European countries.

In its proposed methodology, the agency takes into account the fact that reliance on a cover pool only arises after a long chain of adverse events, including failure of the resolution and recovery process resulting in actual insolvency of the issuer. Consequently, while the level and quality of a cover pool still represents one of the pillars of covered bond ratings, the scenario in which the cover pool becomes the main source of repayment to covered bond investors has become increasingly remote.

Under the proposed methodology, Scope´s rating of the bank (i.e. the Issuer Credit Strength Rating, or ICSR) is the starting point for the covered bond rating. “The proposed methodology reflects our fundamental view that the new regulatory environment provides sufficient support for investment-grade banks to issue covered bonds up to the highest rating levels,” said Karlo Fuchs, Head of Covered Bond Ratings at Scope.

Introduction of resolution regime as a game changer
The proposed methodology reflects the improved credit characteristics of covered bonds due to their significantly lowered probability of default. Neither a regulatory resolution event nor the now more unlikely insolvency of the issuer will legally impact a covered bond´s ongoing performance. “Analysis of the covered bond issuer and assessment of the resolution framework applicable to it are the lynchpin of Scope’s covered bond analysis,” said Fuchs.

As one of the few debt instruments that cannot become bailed-in in a resolution of the bank, covered bonds enjoy a unique degree of protection within the liability structure of banks. “In our view, the much enhanced regulatory architecture, in particular the introduction of the bank recovery and resolution directive in the European Union on 1 January 2015, as well as similar resolution regimes in other countries, is a game changer,” added Sam Theodore, Managing Director for Bank Ratings at Scope.

Forward-looking cover pool assessment as central to the analysis
Detailed and forward-looking analysis of the cover pool and its ability to support the repayment of the covered bonds remains a central consideration for the credit differentiation of covered bonds, beyond the protection resulting from the resolution regimes.

The additional rating uplift provided by the cover pool depends on how resilient against credit, market, counterparty and refinancing risks that cover pool is. The proposed methodology also reflects the fact that following a resolution, the risk profile of the cover pool will continue to evolve until an insolvency event.

No mechanistic application of country and counterparty risks
As in its ratings of financial institutions and structured finance issuances, Scope does not mechanistically limit the maximum rating achievable by a covered bond according to the sovereign rating for the issuer’s country or the origination of the cover pool. While macroeconomic factors play an important role in Scope’s rating analysis, the agency believes that the credit quality of a sovereign is not a suitable basis for imposing a rating cap, particularly in Eurozone countries, as it does not allow for an adequate relative ranking of covered bonds’ credit quality.

Call for Comments
Scope invites issuers, investors and other interested parties to comment on the methodology by 3 April 2015, as part of the agency’s ongoing commitment to open dialogue with market participants. Please send your comments to service@scoperatings.com. Scope will review market participants’ comments on the proposed methodology and will publish the final version of this rating methodology report thereafter.

Analyst Conference Call
At 04:00 PM on 26 February, Scope Ratings will conduct a telephone and web conference to inform in detail investors and issuers on the new methodology. Karlo Fuchs will present the key aspects and will be available to answer questions. To register

Download the proposed Covered Bond Rating Methodology

Related Methodologies and Research
“Bank Rating Methodology”, published February 2014 and further supporting bank methodology publications
“Rating Methodology Guidelines: Structured Finance Instruments (SFI)”, published July 2014
“Legal Risks in Structured Finance – Analytical Considerations”, published January 14, 2015