Moody's swaps bail-in bet splits banks and buy side

In the next crisis, ratings agencies believe derivatives are less likely to be bailed in than bonds, so they should be rated higher. One agency has already taken the plunge, but buy-side firms are wary and the eurozone’s resolution chief has warned it is not a safe assumption

Buy-side firms are not ready to take the plunge. Pic: Stephen Lee

Moody's Investors Service recently did something brave and far-sighted. Or, perhaps, reckless and wrong-headed. It will be hard to tell until the next time a big bank is staggering into the void. When that happens, the rating agency believes derivatives counterparties exposed to the bank are unlikely to lose money under new resolution rules. Senior bonds will be used to recapitalise the bank instead – a forecast that, for the first time, de-links the ratings for the two and sets derivatives liabilities on a higher pedestal.

It is, though, a judgement call on an untried regulatory framework. And while dealers are delighted – one says his reaction to the new methodology was that Christmas had come early – buy-side firms are not yet ready to trust Moody's judgement.

"The banks will be pushing for it, but whether our side of the market is prepared to accept it is a different question. The presumption that derivatives exposures will get some kind of preferential treatment is untested, so no-one knows what is going to happen and who will get what in a future crisis," says Barry Hadingham, head of derivatives and counterparty risk at Aviva Investors in London.

That may be true, but some of the architects of the resolution framework – including Wilson Ervin, vice-chair of Credit Suisse, and co-originator of the bail-in concept – argue it is sensible to conclude derivatives will get a pass. Their stance is consistent with international proposals on total loss-absorbing capacity, which exclude derivatives from the liability buffers earmarked for bail-in (see box, Reading TLAC's tea-leaves). But there is no exclusion in Europe's equivalent regime, and in May, the European Banking Authority (EBA) published detailed proposals on how derivatives valuation would work in the context of bail-in.

Decisions about where to inflict bail-in losses ultimately fall to the relevant resolution authority, in line with local rules, such as Europe's Bank Recovery and Resolution Directive (BRRD) – and, in an interview with Risk, the chair of the eurozone's new authority fires a shot across the agencies' bows.

There is a big difference between anticipating something and it really happening

"I will leave any decision by the rating agencies to the rating agencies. If they come to the conclusion that it is highly unlikely derivatives will be bailed in, they might be right or they might be wrong. It's clear guaranteed deposits are not bailed in. But why should derivatives businesses be sacrosanct for ever? The agency that deems them untouchable might find itself in a tough spot vis-à-vis its clients come post-resolution Monday morning," says Elke König, who took the reins at the Single Resolution Board (SRB) in March, after leading Germany's prudential regulator for three years.

But the debate is not just about what happens at some far-off date. It is immediately relevant, for example, to securitisations, which are rated partly on the creditworthiness of the swap provider to any deal (see box, CRA – structured finance saviour?). Many other buy-side firms have mandates barring them from trading with banks below a certain rating, and bilateral swap contracts often allow one side of the trade to terminate if its counterparty is downgraded to a specified level. Typically, the senior debt rating is used in all of these situations, and bank clients now have to decide whether to embrace the new, higher level for swaps – essentially allowing a bank to slide further into distress before the ratings trigger becomes relevant.

Along with Aviva, other firms – including Aberdeen Asset Management, pension adviser Cardano, and Legal & General Investment Management – are not yet sold (see box, "The question is how much you are going to lose").

"Several banks called us to discuss the topic and got very excited about this, because it gives them an uplift – which some of them really need – but from our perspective we still need more clarity. There is a big difference between anticipating something and it really happening," says Dan Lustig, a senior credit analyst at Legal & General Investment Management in London.

Bail-in waterfall

The Moody's counterparty risk assessment (CRA), published in March, captures the probability of default for counterparty obligations based first on an assumption about where the liabilities will sit in a bail-in waterfall, and second, the volume of liabilities lower down the scale. Counterparty obligations include covered bonds, derivatives, letters of credit, third-party guarantees, servicing and trustee obligations and other operating obligations.

That analysis is used to determine how many ratings grades higher the contractual obligations should sit above the bank's adjusted baseline credit assessment - this is the bank's probability of failure, taking into account support it would receive from its affiliates. In the US and Europe, based on Moody's interpretation of resolution frameworks and the likely behaviour of the authorities, the CRA is always higher than the senior unsecured debt rating, except in cases where both hit the methodology's three-notch uplift ceiling (see figure 1).

The CRA for going-concern operational resolution regimes, Moody's says, is "based partly on the formal position of liabilities in insolvency", and "partly on our judgement that in practice, some obligations will receive preferential treatment regardless of the liquidation hierarchy". The bet is authorities will honour operating obligations to "preserve a bank's critical functions and reduce potential for contagion".

That judgement is the contentious bit. Bailing in derivatives is seen as more complex and more systemically risky – bail-in would happen by closing out trades, and might create knock-on effects as creditors seek to replace broken hedges during a period of market upheaval. Moody's and its backers expect authorities to take this into account.

So, what does the BRRD say about it? There are some certainties – derivatives can be bailed in – but there is no formal hierarchy for senior liabilities within the BRRD, meaning resolution authorities have to refer to national frameworks. Germany is currently considering legislation that would create a clear waterfall of liabilities, and France may follow suit (see box, Europe's subordination choices).

Although derivatives could be hit, the directive limits the scope and procedure. Trades would need to be closed out for the purposes of bail-in, and valued taking into account netting agreements. Liabilities are exempt if they have a remaining maturity of less than seven days or are fully secured, as there is no way to impose a haircut on collateral already posted – a de facto exemption for cleared derivatives. Any amount owed to the bank's counterparty that is not covered by collateral, however, could be bailed in – a potentially crucial point because incoming rules on mandatory bilateral collateralisation incorporate an exposure threshold of €50 million below which margin is not required.

For derivatives that are in scope, broad get-out clauses may apply. The resolution authority is expected to conduct something resembling a cost-benefit analysis, and has the option to exclude liabilities if bail-in would impact the ability of the institution to continue critical functions, cause contagion, or cause destruction of the liability's value beyond the loss-absorption capacity liberated by closing out the derivative. Trades would also be safe if bail-in cannot be carried out in a reasonable amount of time.

"With the fundamental change in bank regulation, creating a new world of bail-in, we believe the rating of senior unsecured debt is no longer the most appropriate point of reference for these derivatives obligations," says Ana Arsov, a New York-based associate managing director at Moody's. "As a rating agency, we consider various factors impacting credit risk, including regulations, and assign probabilities to specific events. We believe regulators are likely to honour derivatives transactions and other operational liabilities in an effort to conduct an orderly resolution and keep contagion from spreading to other parts of the financial system. Of course, as regulation evolves, we will seek to adapt our analysis accordingly to reflect the changing landscape."

Banks take credit

Privately, banks claim some credit for the agencies' change of heart: "We put some presentations together and went to the agencies, and said ‘We just want you to think about these things'. For example, there are parts of BRRD that make it very clear secured derivatives would be safe from bail-in. We just wanted to make sure they were at least discussing this, because so many counterparties use the senior unsecured debt rating as a reference, and because of these regulatory changes, those reference points are not as accurate as they used to be," says a structured finance specialist at one bank.

The industry's argument may have been self-interested, but that does not make it wrong. Resolution experts – including current and former regulators – broadly agree the CRA makes sense.

"Short-term instruments would have a very low likelihood of being bailed in because of the impact that would have on liquidity and funding, and the trajectory of failure. But if you have longer-term, more bespoke derivatives, those in general could be subject to bail-in," says Michael Krimminger, partner at law firm Cleary Gottlieb Steen & Hamilton in Washington, DC, and former general counsel at the Federal Deposit Insurance Corporation (FDIC).

"That being said, our experience in the crisis has been that counterparties and market participants tend to lump things in broad categories, so if you bail in longer-term derivatives, it could very likely have an impact on the liquidity of the market for shorter-term instruments. Given that risk of contagion across instruments, I think authorities would rather go to the resolution fund before they would want to impact the derivatives markets through bail-in of those derivatives," he says.

Jim Wigand, a managing director at Millstein & Co in New York and former director of the office of complex financial institutions at the FDIC, also supports Moodys' stance, but adds some caveats: "In the context of a resolution framework, it's unlikely any resolution authority or regulator would be willing to say derivatives are fully protected and safe from prospective bail-in or becoming a claim. No-one can credibly give that type of guarantee, because we don't have the foresight to envision every situation that might unfold, and certain circumstances could arise where most types of obligations need to be bailed in. That being said, authorities are making an effort to establish a clear priority of a company's obligations. I think the vision is emerging as to what regulators desire to achieve with respect to creating a set of senior liabilities."

The European Banking Authority (EBA) is starting to work through some of these issues. In May, it published a consultation paper on the valuation of derivatives in resolution – a responsibility handed to it by the BRRD – which details how resolution authorities are expected to value and compare derivatives during bail-in proceedings. When a derivative is closed out, a net payment from one counterparty to the other is calculated across all their trades, taking collateral into account. If a derivative is collateralised, the party that is in-the-money will already have most, if not all, of what it is owed, as long as the mark-to-market value does not shift wildly between termination and valuation.

Early termination of a contract, however, can lead to additional close-out costs, and resolution authorities are expected to take these into account. If the result would be a loss greater than that covered via the bail-in, then an authority is free to exempt those liabilities from the process.

The process is described in straightforward terms in the EBA proposals, but traders warn it would be anything but. The plan is that counterparties at risk of bail-in would be notified by the resolution authority and asked to provide values for "commercially reasonable" replacement trades by a set deadline. If they do not, resolution authorities would be left to determine close-out amounts using mid-market prices and replacement costs based on bid-offer spreads.

The obvious objection is that it would be hard to know how much liquidity will be available when the market reopens, says the head of counterparty exposure management at a European bank: "Determining whether to include or exclude derivatives for bail-in based on expected close-out costs sounds quite theoretical. One could easily imagine scenarios in which this uncertainty in the derivatives space might add to market volatility and make the parts of derivatives markets that are deemed too costly become even more illiquid at a time of stress, resulting in a self-fulfilling expectation that they would be hard to replace."

In essence, this means bail-in of derivatives depends a lot on how successful the resolution process is at containing market turmoil; it might be relatively easy to replace bailed-in hedges following a smooth resolution. Interpretations of the remaining exemptions – based on the potential for systemic instability and contagion – are equally complex, but are also key to deciding whether one can assume all derivatives are in fact exempt or not.

"Legally and practically speaking, derivatives can be bailed in, though because most derivatives are collateralised or centrally cleared, the amount would be small. But it raises some problems around the valuation of derivatives that are not trivial. It's case-by-case analysis; it's not systematic. But I think there should be convergence in how this evaluation is carried out with the Regulatory Technical Standards being drafted by the EBA," says Olivier Jaudoin, director of resolution at the French prudential supervisor Autorité de Contrôle Prudentiel et de Résolution.

For Credit Suisse's Ervin, these kinds of considerations are precisely why it makes sense to assume derivatives will not be at the top of the bail-in list: "Should we differentiate between senior debt and derivatives ratings? Absolutely. Different treatment is not guaranteed, but credit ratings are about probabilities and reasonable expectations. They are not like Newton's laws of physics.

"I understand why people are nervous, and it's something that needs to be monitored. But a bail-in of a derivatives book is irrational, difficult and dangerous in most cases, which is why regulators have put so much effort into the Isda protocol to avoid unwinds in resolution. If it's rational for a resolution authority to preserve a swap book – and that helps the world get from a scary Friday night to a safer Monday morning – then I think it's a smart bet."

 

"The question is how much you are going to lose"

Conceptually, it makes sense; practically, it's difficult to trust. That, in a nutshell, is how buy-siders see the counterparty ratings assessment (CRA) launched by Moody's Investors Service in March this year. Here, three firms share their concerns.

Dan Lustig, a senior credit analyst at Legal & General Investment Management in London: "The CRA assumes all regulators in every jurisdiction will behave in a very logical way, and that's not always the case. We've seen authorities during the crisis save Bear Stearns while they allowed Lehman Brothers to fail. Second, the CRA is not yet reflected in the existing hierarchy of claims based on Europe's Bank Recovery and Resolution Directive."

Max Verheijen, head of financial markets at pension adviser Cardano in Rotterdam: "It's a good thing to monitor ratings that are relevant for me as a derivatives counterparty. But does the CRA sufficiently cover my obligations and rights under derivatives contracts? I'm not sure. Are my derivatives considered operational obligations? Is the preservation of the interest rate swaps I'm doing considered important for financial stability - so, do they fit the local transposition of the BRRD? I don't know. If someone from Moody's can convince me, I will make a point to move to the CRA. But before we incorporate this into legal documentation, we have to make sure it will stand if a counterparty defaults."

Gregory Laloum, London-based head of counterparty risk at Aberdeen Asset Management: "If your counterparty in a derivatives position goes down, you could be in trouble. The question is not how much trouble compared to a bond holder, rather how much you are going to lose. If we rely on classifying in an exact and granular manner where we stand in terms of seniority of creditors, then I think we are taking a risk. With new bail-in rules and legislation, saying a derivatives counterparty to a bank is definitely more secure than an unsecured creditor is fine in theory, but in reality, you still never really know how much you will lose, and that is the important bit."

Moody's says its decision to make the CRA a probability-of-default measure, and not to consider potential losses, was based on feedback from market participants, and that it would be willing to reconsider if asked.

 

Reading TLAC's tea-leaves

As part of new resolution frameworks, banks will be required to hold buffers of liabilities that can be bailed in. What they are allowed to include in these buffers seems to highlight a division among regulators about whether derivatives should be bailed in at all.

The Financial Stability Board's proposals on total loss-absorption capacity (TLAC) requires bail-inable liabilities to total up to 20% of a bank's risk-weighted assets (RWAs). Derivatives are explicitly excluded from the buffer. Eligible components must be subordinated to all excluded liabilities, or - up to 2.5% of RWAs - rank pari passu with them. TLAC, which takes effect in 2019, is only meant to cover global systemically important banks, currently totalling 30 institutions.

"Derivatives not being included in TLAC should reduce dramatically their likelihood of being bailed in. The standards for what could be bailed in and what can be counted as part of your TLAC buffers for bail-in are not exactly the same, but I hope they will coalesce over time," says Michael Krimminger, partner at law firm Cleary Gottlieb Steen & Hamilton in Washington, DC, and former general counsel at the Federal Deposit Insurance Corporation.

Meanwhile, Europe's Bank Recovery and Resolution Directive incorporates a TLAC equivalent, known as the minimum requirement for own funds and eligible liabilities (MREL). It applies to all EU banks, is set on a bank-by-bank basis, and is more ambiguous than the international version. The European Banking Authority (EBA) draft regulatory technical standards for defining MREL say resolution authorities "should also consider the possibility that certain classes of liabilities, to be identified in resolution plans ... might be excluded from bail-in", and exclude those from MREL. The EBA says MREL will be implemented for G-Sibs in a way consistent with TLAC.

 

CRA – structured finance saviour?

Judgement call or not, in the world of structured finance, the counterparty ratings assessment (CRA) is already being used.

In a classic transaction, a pool of assets is placed with a bankruptcy-remote special-purpose vehicle (SPV). The SPV issues debt, and then pays its obligations to noteholders using the return from the underlying assets. Swaps are used to smooth over interest rate, currency or timing differences between earnings on the collateral and payments to noteholders, so the strength of the swap provider is a risk that needs to be managed. Within the swaps are two triggers based on external ratings: if the first is breached, the swap provider has to post an additional collateral amount; hitting the second disqualifies the bank from acting as the counterparty and obliges it to find a replacement, which can be difficult.

Trigger levels vary from deal to deal, and are not made publicly available on a widespread basis. A Moody's Investors Service report from 2012 about swaps counterparty downgrades shows first-level triggers for collateral posting between A3 and A2. Second-level triggers requiring swap counterparty replacement were anywhere between B3 and Baa1, though the majority were Baa3 and Baa2.

The reference for these triggers was traditionally the rating for the swap provider's senior unsecured debt, but the publication of the CRA allows these contractual protections to be tied to something ostensibly more appropriate - the chance of default for the swaps themselves, rather than the swap provider's bonds.

"It's pretty much standard to reference the CRA now for new deals, because it would be fairly standard for the Moody's downgrade provisions in swap agreements to refer to the CRA rather than a debt rating," says Richard Tredgett, a partner at Allen & Overy in London.

That is wonderful news for dealers, many of which have been instantly catapulted back into the safety zone (see table) "Our senior unsecured rating for Moody's is at Baa1, and then just last week we were assigned a CRA of A3. That effectively gives us more possibilities to act as a swap counterparty in structured finance transactions. We think it's really beneficial to make the distinction because it opens up the number of players in the market. What we saw in the past was that criteria were becoming more stringent, so senior unsecured ratings were going down and the available universe of counterparties became very limited," says Bart Verwaest, head of asset-backed securitisation solutions at Belfius Bank in Brussels.

Moody's released a report in June showing 36 structured notes and repackaged securities ratings were upgraded as a direct result of the CRA assignment to 13 global investment banks.

"In a number of deals, our ratings have gone down, and we have had to find replacements. So obviously as an institution, we are interested in the criteria changing so we can do that business again," says one head of asset-backed finance at a German bank. Could existing contracts be amended to reference the CRA as well? Possibly. Banks note that many contracts will need to be revised over the coming year to make them compliant with new rules on margining for non-cleared trades, but they are facing a difficult sell.

"There would be resistance to amending back contracts, because effectively all you're doing is lowering the existing trigger. People aren't going to look at it and say ‘There's a new rating, we'll just reference that instead'. These historic triggers have significant value for clients, and we are not going to give these up lightly," says Mark Ryan, a senior derivatives and counterparty risk manager at Aviva Investors in London.

 

Europe's subordination choices

The other component of the Moody's Investors Service resolution bet relates to subordination. Here, a lot depends on which country a defaulting bank is from.

In the UK, many financial institutions are structured to have subordinated holding companies, which have liabilities such as senior unsecured debt on their balance sheets, flanked by subsidiaries that hold operational obligations. In this case, bank structure makes the waterfall clear, but holding companies are less common in continental Europe - instead, subordination is more likely to depend on statutory or contractual provisions.

Germany is proposing a statutory change. To provide more certainty about eligible liabilities for bail-in buffers, banking law could be amended to state that senior unsecured debt is subordinate to other senior liabilities - a development end-users say would allow them to embrace the Moody's counterparty rating assessment (CRA) and equivalent methodologies.

"If the bill in Germany goes through, certainly we would start to use the CRA for German banks, because what you can anticipate is clear. Then if the French follow suit, maybe this will catch on throughout Europe," says Dan Lustig, a senior credit analyst at Legal & General Investment Management in London.

In Spain and Italy, however, a contractual approach is expected to persist.

While the Single Resolution Board could push for more convergence, this will be difficult in some countries, analysts say - pointing to Italy and Spain as examples.

"In Italy, a material amount of existing senior debt is sold onto the retail client base. Can you implement a statutory solution that means bailing-in retail investors, which are very likely to also be depositors in those institutions? Meanwhile, in France, you have institutions with large leveraged balance sheets, so issuance requirements to meet loss-absorption buffers would be quite significant. They would be lobbying quite hard to get a German solution so they don't have to issue special new instruments at a higher cost," says Roberto Henriques, head of European financials credit research at JP Morgan in London.

The lack of uniformity muddies the subordination picture, since countries that go down the contractual route will issue new senior debt instruments subordinate to existing senior debt, meaning it wouldn't be clear that all senior liabilities encompassed by the CRA would necessarily rank above old senior debt. "Everywhere else but Germany, you could argue that senior bondholders still enjoy some kind of additional protection, as banks issue alternative loss-absorption instruments," says Henriques.

Though bail-in experts expect derivatives to enjoy similarly high ranking in all three approaches - structural, statutory and contractual - for some buy-side firms the fear is establishing seniority through the contractual route means subordination could be open for contestation and unpredictability.