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3. The relationship between bail-in, CDS and rating

3.4 Ratings

The third dimension included in my analysis is the degree of creditworthiness of banks. For this indicator I chose to rely on the data provided by the rating agency Moody’s, one of the top provider of credit evaluations together with Standard & Poor’s and Fitch. It has been estimated that they control nearly 95% of the credit ratings market, in large part because

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their status was protected in the original Securities and Exchange Commission regulations of the sector of 197547.

I decided to base the comparison with the bail-in resilience and the CDS spread on the rating given to the unsecured debt. Unsecured debt, being the portion of debt not backed by a guarantee or any other type of asset, is clearly riskier than a secured debt. For this reason, the rating on the unsecured debt reflects the issuer rating in most cases.

3.4.1 Moody’s methodology

The Moody’s methodology for a comprehensive rating assignment can be divided in three different stages. First, a raw assessment, based on fundamental credit factors, is determined by a Baseline Credit Assessment (BCA). Then expectations related to various forms of external support are incorporated within a Joint Default Analysis. Finally, the BCA is enhanced with other considerations in rating the obligations of related entities such as specialized covered bonds issuers and bank holding companies and bank obligations in failure

or default48. I chose to make exclusively use of the raw BCAs because they reflect Moody’s

opinion of the bank’s intrinsic, or standalone, strength absent of any extraordinary support from affiliates or government. The BCAs are not a rating tout court but a primitive assignment of a bank’s probability of requiring support to avoid a default, or defaulting on a debt obligation49.

The BCA scorecard is a simple reference tool to approximate the credit profile of financial institutions under the assumption of no external support. It is expressed as a three- notch range on an alphanumeric scale, which goes from the lowest, C, up to triple Aaa.

47 Council on foreign relations (February 2015), web source. 48 Moody’s INVESTOR SERVICE (September 2017). 49 Ibidem.

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Figure 13. Moody's BCA scale

Source: Moody's Investor Service

Banks are financial institutions specialized in risk and maturity transformation. The intrinsic strength of a bank, therefore, depends principally on the extent of the transformation undertaken and the resulting risks. Consistent with this, the Moody’s approach in determining a bank’s relative financial strength is focused on the view that its strength, and, hence, its viability, is largely a function of its solvency and its liquidity, which are the characteristics to which are assigned, respectively, 65% and 35% weight (Table 4). Solvency could be defined as the combination of asset risk, leverage and earnings, while liquidity is determined by a bank’s funding profile together with its ability to access cash. Moreover, these factors are related: all other variables being equal, stronger capitalization increases the capacity to absorb losses, increasing the confidence of counterparties and reducing the risk of a liquidity problem. Greater liquid assets, meanwhile, indirectly enhance solvency because they imply that a bank is less likely to need to sell illiquid assets at a loss in the event of a funding problem. The reverse is also true, and weak solvency can undermine liquidity.

Therefore, in order to analyse each bank’s financial profile, Moody’s identifies five fundamental credit sub-factors (Table 4): asset risk, capital, profitability, funding structure and liquid resources.

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Figure 14. Overview of weights to address the Financial Profile

Once explained why Moody’s perspective on rating could be a good proxy for the credit quality of the unsecured debt, I collected the data in table 6.

As occurred with the CDS on unsecured debt, not all ratings were available. Thus, the final sample includes 24 of the initial 26 banks composing the Euro STOXX index, with the Italian institutions Mediobanca and Fineco Bank out of the list.

Red cells stand for a downgrade in the credit quality of the senior unsecured debt with the respect to the previous year, while green cells stand for the opposite. In few cases the rating was withdrawn (yellow cell) by Moody’s. There may be several reasons sometimes unrelated to the creditworthiness of the issuer. Should no rating be assigned, the reason may be one of the following:

I. An application was not received or accepted.

II. The issue or issuer belongs to a group of securities or entities that are not rated as a

matter of policy.

III. There is a lack of essential data pertaining to the issue or issuer.

IV. The issue was privately placed, in which case the rating is not published in Moody's

publications50.

In line with the better economic conditions after the turmoil occurred on many sovereign debts in 2011 (especially for PIIGS countries), the trend in rating is positive with the number of downgrades drastically reduced from year to year. However, the most trusted banks

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resulted to be the French BNP Paribas and Crédit Agricole, that never experienced a downgrade.

Table 6. Moody's ratings of senior unsecured debt

Bank 2011 2012 2013 2014 2015 2016 Legend

BNP Paribas SA A2 A2 A2 A1 A1 A1

Deutsche bank AG A2 A2 A2 A3 A3 A3 Upgrade

Credit Agricole SA A2 A2 A2 A2 A2 A1 Downgrade

Societé Generale SA A1 A2 A2 A2 A2 A2 WithdrawnWithdrawn Banco Santander SA Not found Not found Baa1 Baa2 Baa2

UniCredit SpA A3 Baa2 Baa2 Baa2 Baa1 Baa1

ING Groep NV A1 A3 A3 A3 Baa1 Baa1

B. Bilbao Vyzcaya Argentaria SA Aa3 Baa3 Baa3 Baa2 Withdrawn Baa1 Intesa Sanpaolo SpA A2 Baa2 Baa2 Baa2 Baa1 Baa1

Natixis SA Aa3 A2 A2 A2 A2 A2

Commerzbank AG A2 A3 Baa1 Baa1 Baa1 A2

ABN Amro Group NV Aa3 A2 A2 A2 A2 A1

Caixa Bank SA A3 Baa3 BAa3 BAa3 Baa2 Baa2 KBC Group NV A2 Baa1 Baa1 A3 Withdrawn Baa1 Banco de Sadabell SA Baa1 Ba1 Ba1 Ba2 Ba1 Baa3 Erste Group bank AG A3 A3 A3 Baa2 Baa2 Baa1

Bankia SA BAa3 Ba2 B1 B1 B1 Ba3

Bank of Ireland Group PLC bA2 Ba2 Ba3 Ba1 Ba1 Baa2 Unione di banche italiane SpA A3 Baa2 Baa3 Baa3 Baa2 Baa3 Raiffeisen Bank International AG A1 A2 A2 Baa1 Baa2 Baa2 Allied Irish Banks PLC bA3 Ba3 B1 Ba3 Ba1 Baa3

BankInter SA A2 Ba1 Ba1 Baa3 Baa2 Baa2

BPER Banca Not found Not found Not found Ba2 Ba2 Popolare di Milano BAa3 Baa3 B1 B1 Ba3 Ba2

Source: Moody's site

3.4.2 The numeric equivalent

The alphanumeric scale can be converted into a pure numeric scale according to a precise conversion, proposed by Moody’s itself. The best rating (aaa), coincides with a numeric equivalent of 1, while to the worst (caa3) corresponds a numeric equivalent of 19.

Factor score aaa aa1 aa2 aa3 a1 a2 a3 baa1 baa2 baa3 ba1 ba2 ba3 b1 b2 b3 caa1 caa2 caa3

Numeric equivalent 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

In this way the baseline credit assignments are made easier to handle so that a comparison among companies rating will be more intuitive.

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