DBRS has announced that it:
has today released its methodology for rating Bank Preferred Shares and Equivalent Hybrids.
This methodology addresses the level of notching for preferred shares and equivalent hybrid instruments (collectively, preferred shares) relative to issuer ratings for banks and other financial institutions that are highly leveraged relative to the leverage seen in most corporate issuers. For simplicity, we will refer to banks, but the methodology applies to certain other financial institutions that fit this profile. The combination of high leverage and the importance of adequate capital for a bank’s viability increase the risk of nonpayment of preferred share dividends and/or adverse exchange offers of common equity for preferred shares relative to the risk for similarly-rated corporate issuers. These actions provide ways for a bank to quickly build up loss-absorbing common equity. The inclusion of “equivalent hybrid” denotes that this methodology also applies to hybrid securities that either convert into preferred shares rather than into junior subordinated debt or have other characteristics whereby DBRS would treat the instrument in the same fashion as it would preferred shares.
In summary, there are two major changes occurring in this methodology relative to the prior DBRS methodology for rating bank preferred shares.
(1) For those banks that benefit from support, the starting point for notching preferred share ratings will now be based on the intrinsic assessment (IA) rating rather than on the final senior debt rating. The DBRS support assessment methodology means that the IA is usually lower than the final senior debt rating for such banks. This change reflects the view that external support should provide no rating uplift for equity-type securities.
(2) The degree of notching from the IA rating to the preferred share rating has been widened to reflect our perception that the risk in these capital instruments has increased, although there is some flexibility to make adjustments to reflect the position of individual banks. This extends the long held core principle of rating more junior securities at lower levels. In addition to the implied higher risk of default, this also in part recognizes that there is a higher expected loss for junior securities that default than for more senior ranking securities.
The methodology itself has been made available. A lot of the rationale for the changes is regulatory:
Increasing the risk in these instruments is DBRS’s perception that regulators and governments are now more committed to making capital instruments play the role that they were created to play – that is, to provide capital. To get government support, banks may face greater pressure to take such capital-enhancing actions either before or in conjunction with getting government support.
An additional factor that is likely to increase the risk of such adverse actions for preferred shares appears to be the reversal of more than a decade of increased reliance on preferred shares and other hybrid instruments to bolster regulatory capital. Given the loss-absorption role of common equity, the financial markets and increasingly the regulators are looking to banks to bolster their common equity capital as opposed to other forms of capital. This drive has become more acute after the rapid erosion of common equity that some banks experienced due to significant writedowns.
Notching will vary with issuer strength:
The weaker the institution, the greater the probability that a nonpayment of preferred shares will occur after a significant loss or deterioration in fi nancial health. That suggests a widening gap as a bank’s senior issuer rating is lowered. For example, in the base notching scale shown below, for banks with an intrinsic assessment rating of A (low) or below, the risk for preferred shares is perceived to be non-investment grade.
They provide a base-case notching yardstick:
| DBRS Notching Guideline | ||
| Senior | Preferred Shares | Notes |
| Three Notches | ||
| AA (high) | A (high) | DBRS alerts investors to higher risk of nonpayment, even for highly rated banks |
| AA (low) | A (low) | Risk is still very low as identified by “A” category |
| Four Notches | ||
| A (high) | BBB | For A (high) banks, less resiliency and increased risk of adverse events affects the preferred share rating |
| A (low) | BB (high) | Risk of falling into BBB category with higher capital stress means non-investment grade rating for preferred shares |
| Five Notches | ||
| BBB (high) | BB (low) | More immediate pressure to raise capital, if needed, but may be more difficult for weaker BBB bank |
| BBB (low) | B | Bank is only one notch away from non-investment grade, making capital more difficult to raise if needed |
While the base notching as discussed above is the starting point for every rating decision on bank preferred shares, DBRS policy permits exceptions to the base notching for all rating levels (either above or below) to reflect the unique considerations of individual banks. Key considerations include the following:
• Mix and strength of the capital structure (including the proportion of preferred shares in the capital structure).
• Actions taken on common dividends (recognizing that these actions are the first buffer).
• Any other unique stresses or lack of stress within the domestic financial system, such as the expected actions possible from external parties (regulators, governments).
• The robustness and expected consistency of the bank’s earnings.
• Accessibility to capital markets.
• When the aforementioned factors present a strong case, other possible considerations may also include where the IA rating is within the broader rating category and whether the issuing entity is the bank or the holding company
This is the methodology used in the course of the recent DBRS Mass Downgrade of Banks.
