Moody's U-turn on bank rating methodology
Last week the United Kingdom Prudential Regulation Authority released a discussion paper on the implementation of ring-fencing of core UK financial services and activities within banking groups with core deposits of more than £25 billion. The UK government has legislated for ring-fencing to come into effect from January 2019.The PRA will undertake consultation on the implementation of ring-fencing regulations throughout 2015 and intends to produce the final rules in 2016. Moody's Investor Service has raised concerns about the proposals put forward. While the ring-fenced banking (RFB) entities should be less volatile than the wholesale and investment banking activities of the larger banking group and therefore have less credit risk, they will be inherently less complex and easier to resolve, should a RFB get into trouble.In other words, the RFB's will have high levels of deposit funding but very low levels of wholesale senior and subordinated debt, thereby increasing the risk to creditors that they will be bailed-in in the event of failure of the RFB. This is undoubtedly true, but it sounds like Moody's wants to have its cake and eat it too.Lending to any borrower comes with the risk that the borrower may default and the lender will lose money as a result of the default. Surely, the advantage of the RFB to bondholders is that its credit risk is lower than that of the broader banking group.It is also difficult to imagine a situation where a RFB would fail and the broader banking group would not. The rationale for ring-fencing is to remove the RFB from the consequences of failure in the broader, riskier banking group.Moody's acknowledged that the broader banking groups would present a higher level of credit risk and, with their core banking activities ring-fenced, there was less likelihood that systemic support would be forthcoming should the broader group get into difficulty. This is despite the likelihood of a high degree of interdependency between the broader banking group and other capital market participants. Moody's said that a workable process to impose losses on the creditors of RFBs, the broader banking group, and the holding company (if any) would not only reduce the likelihood of government bailouts but also the need for regulatory forbearance of capital shortfalls that may occur at any of the group entities.It sounds like Moody's is preparing investors for changes to its banking methodology, which is currently under review. It seems likely that Moody's will take the view that risks for UK bank bondholders (at least) are increasing, both in terms of the probability of default and loss given default, and will be lowering bank credit ratings accordingly.This would be a significant change from Moody's joint probability of default methodology implemented mid-last decade. The methodology assumed an implicit government guarantee of systemically important banks and saw many assigned 'Aaa' ratings, albeit briefly.