DBRS Clarifies its Approach to Rating Bank Subordinated Debt and Hybrid Instruments

DBRS today clarified its approach to rating subordinated debt, junior subordinated debt and hybrid debt that does not convert to preferred shares of banks, bank holding companies and banking groups. This clarification addresses several aspects of bank debt that are being impacted by recent events and changes in the relative risk across the wide range of these debt instruments. In light of recent regulatory action, the clarification principally addresses debt that has discretionary payments and the impact on ratings of actual deferrals. Earlier this year, on 4 April 2009, DBRS took action by downgrading most preferred shares to better align the ratings with the risks inherent in these instruments. In the coming weeks and reflecting ongoing regulatory action related to the halting of discretionary payments, DBRS will take action on subordinated debt and hybrid instruments as appropriate under its policies.

Notching Debt Instruments from Final Rating
This clarification is focused on debt and debt-like instruments. Accordingly, the notching for subordination and other characteristics starts from the senior unsecured rating (the final rating), which can benefit from systemic support. DBRS views this rating as the best representation of the likelihood of default or insolvency of the bank, bank holding company or banking group. The notching represents the additional risk in terms of expected loss or other adverse outcomes relative to the position of senior debt. While these debt instruments are often viewed by regulators as having capital characteristics, their nature means that their ability to provide a capital cushion to depositors and senior debt holders can generally only play a major role when there is an insolvency or a bank seizure. In effect, the capital characteristics are generally only achieved when the bank or issuing entity has become a “gone” concern. If the debt instruments have other features that significantly increase the extent of any additional risk in terms of expected loss, for example with principal reduction terms where triggers are readily breached, this additional risk is reflected in the notching.

For preferred shares and other hybrids that convert to preferred shares or equity like instruments, DBRS notches the ratings for these instruments from the intrinsic assessment. DBRS views these instruments as considerably more exposed to risk of adverse action by management and/or regulators prior to a bank becoming insolvent or subject to regulatory seizure. This risk is more related to the intrinsic strength of the bank and its need for common equity. Moreover, equity like instruments are unlikely to benefit from systemic support.

One-Notch Differential for Mandatory Pay and Cumulative Discretionary Pay Subordinated Debt Remains Unchanged
For mandatory pay subordinated debt and discretionary pay subordinated debt instruments, where deferred payments are cumulative, DBRS is maintaining its current policy of a one-notch differential between these instruments and the senior debt rating. The same one notch policy applies to cumulative discretionary pay subordinated debt, which is typically junior or deeply subordinated debt. DBRS’ analysis of default and recovery rates supports the opinion, as the differences between subordinated debt and cumulative junior subordinated debt do not warrant a rating notch difference, particularly when consideration is given to the fact that subordinated debt is already rated one notch below senior debt. Both types of instruments are viewed as elements of capital from a regulatory perspective, subject to certain limitations. DBRS does not view the ability to defer payments as a credit risk, but rather, a risk that holders of the deferrable instruments have agreed to as per the contractual terms of the instrument and DBRS does not consider “deferral” as being equal to “default”.

Two-Notch Differential for Non-Cumulative Discretionary Pay Subordinated Debt
For instruments with noncumulative discretionary pay characteristics, the additional risk of payments being skipped is viewed as sufficient to differentiate these instruments by an additional notch from those with mandatory pay or cumulative discretionary pay characteristics. These instruments will now be widened to two notches below senior debt. Again, DBRS views the ability to defer payments as a risk that holders of the deferrable instruments have agreed to under the instrument’s contractual terms and skipping of payments is not equivalent to default, provided that it is performing according to its contractual terms. Other characteristics that add to the risk of these instruments’ ratings are also taken into account. These characteristics include triggers, principal write-downs, regulators’ authority and mandatory payment features. Where these characteristics imply a much greater risk of principal loss before insolvency, further notches could be added.

Notching for Deferral or Skipping of Payments
DBRS will add an additional notch when instruments with discretionary payments defer or skip. This notch will be applied as long as discretionary payments are not being made. This additional notch serves to differentiate between instruments that are still making payments from those that are not paying, but otherwise meeting the instrument’s terms and covenants. As noted already, DBRS does not view the exercising of the right to defer or skip payments as equivalent to default. Typically, a bank that defers or skips discretionary payments is usually in significant difficulty, so that its senior debt rating is already under pressure and its rating has likely been lowered. That results in lower ratings for subordinated debt. Recent examples, however, have illustrated occasions when a bank may defer or skip due to regulatory events, but retain significant strength and remain investment grade. In these circumstances, the senior debt rating remains the principal driver of the likelihood that payments will be resumed and insolvency avoided.

This methodology clarification may impact any rated bank with non-cumulative discretionary pay subordinated debt or hybrid instruments and any bank that has halted payments on deferrable subordinated debt regardless of whether halted payments are cumulative or non-cumulative. DBRS will provide commentary regarding the impact of the aforementioned clarification on a bank-by-bank basis, and expects to conclude this process by 31 January 2010.

The applicable methodologies are:

Rating Bank Preferred Shares and Equivalent Hybrids, June 2009
Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments
Analytical Background and Methodology for European Bank Ratings, Second Edition
Rating Banks and Bank Holding Companies Operating in the United States
Rating Banks in Canada

This is a Corporate (Financial Institutions) rating.