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Global Credit Research Financial Institutions May 29, 2007 New notching mechanism with up to four notches Sector Report - Summary of Moody's JDA For Banks Moody's also published a criteria report titled "Guidelines for Rating Bank Junior Securities", whose purpose is to explain Moody’s rating practices for junior securities issued by banks (known as “notching”) as outlined in the March 2007 JDA for banks methodology report. While leaving the general notching mechanism for subordinated paper unchanged (one or two notches down from the senior rating, depending on the degree of subordination), Moody's stated that it may add one or two additional notches for weaker banks (BFSR of D+ or lower). Once again, the scope for rating committee judgment has increased, making rating forecasts harder. The notching mechanism for subordinated paper has also been adjusted in a way that reflects each sovereign's possibility to impose the depreciation of such paper. The mechanism now ranges from one to four notches, with up to three notches having been applied so far. MOODY'S NOTCHING MECHANISM FOR BANK CAPITAL Typical Regulatory Treatment* Subordinated Lower Tier II and Tier III** Junior Subordinated Preferred shares and other Hybrids with preferred treatment in bankruptcy and/or deeply subordinated debt Hybrids with meaningful triggers*** Bayerische Hypo- und Vereinsbank AG, CA IB International Markets AG, Bayerische Hypo- und Vereinsbank AG Milan Branch See last pages for disclaimer. 6 Most Common Characteristics BFSR of A, B or C Dated, no interest deferral language, subordinated to senior and ahead of jr. sub. in bankruptcy, and preferred. Tier III subject to maturity extension. Upper Tier II Undated, with interest deferral language, cumulative, could be subordinated or pari passu to LT2 but ahead or preferred. Tier I Interest deferral language, cumulative or non-cumulative, ranking ahead of equity. Upper Tier II or Tier I Principal writedown outside of liquidation Principal writedown outside of liquidation Notches below senior BFSR of D BFSR of E -1 -1 -1 -1 -1 -2 -1 -2 Closer to the BFSR implied rating -2 -3 Closer to the BFSR implied rating -2 -3 Closer to the BFSR implied rating up to -2 up to -3 Closer to the BFSR implied rating * Notching is based on differences in expected loss rather than on regulatory capital treatment because the regulatory specifications for such instruments vary across jurisdictions. ** Tier III instruments are rated according to priority of claim (typically subordinated). The risk in such instruments of a maturity extension or interest deferral tied to meeting minimum capital requirements does not significantly affect expected loss. *** Meaningful triggers are those set at a level such that they would be breached when one of the following occurs: 1) the issuer is just beginning to experience financial distress (before it is in severe financial distress) or 2) at a time when issuer may cut or eliminate its common dividend. Source: Moody's; Global Research (HVB)
Global Credit Research Financial Institutions May 29, 2007 Sector Report - Summary of Moody's JDA For Banks OUR EVALUATION OF THE NEW METHODOLOGY Two general problems In our view, the fact that the likelihood of implicit support cannot be quantified, generates two problems: Positive features outweigh shortfalls, in our view, … … even if the shortfalls cover more space for explanation – Moody's new ratings are criticized for being subjective as there is no historical or objective data base which explains the applied support assumptions (however, this is the same as for the other agencies, which do not publish their quantified assumptions). – No one can honestly tell whether Moody's or the others are right. This might be possible in five or ten years, when actual default rates can be compared to assigned ratings. Regarding Moody's new approach itself, there is both good and bad news. On the positive side, we see the following features: – Well-written, in-depth papers on both the BFSR and JDA methodology, covering the assessment of inherent financial strength and external support. – Detailed scorecard for the deviation of the BFSR rating and the support level leads to consistent and structured methodology. – Handy excel-based tools which allow for rating drivers sensitivity analyses. – Structured, easy to read Credit Opinions. The shortfalls of the new framework include: – Rating committees have been given larger scope for judgment, as this is needed to adjust the scorecard process for special situations and nonquantifiable inputs; however, this makes rating forecasts harder, as there is a range of scorecard points for each set of data (particularly regarding support). – In both BFSR and JDA, limits and ranges are subjective and are not explained by historic or objective data. – Moody's might be right in granting more importance to support mechanisms. It makes two basic assumptions: (i) it derives the general probability of a country to support its banks from the strength of the banking system, its importance to the economy, and the history of bank defaults in a very static manner. The problem we see here is that history is not necessarily a good indicator for the future; also, Moody's assumption that financial strength is negatively correlated to the support probability is questionable. (ii) Moody's estimates the probability for each bank to be supported depending on the bank's market share and importance to the financial system's stability. While the implied positive correlation is generally correct, there are two flaws, in our view. First, the probability brackets mentioned above are the same for all countries and the categorization follows a very static approach, with huge impacts on the final default rating. This does not recognize the fact that there are differences from country to country. Second, if a bank is small, the likelihood of it being rescued might be high, as it is easy to do it, mitigating the positive correlation; we should remember that support also includes things such as behind-the-scenes arrangements, e.g. to catalyze a merger process. – The final calibration (transition of scorecard points into rating) is problematic, in our view, as small assumption changes lead to huge rating differences. Bayerische Hypo- und Vereinsbank AG, CA IB International Markets AG, Bayerische Hypo- und Vereinsbank AG Milan Branch See last pages for disclaimer. 7
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