Moody's correct on swaps bail-in risk – Risk.net poll

Nearly 90% say agency is right to assume swaps won't be bailed-in

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Almost 90% of respondents to a Risk.net poll believe ratings agencies are right to assume derivatives counterparties will be safe from a bail-in under new bank resolution rules.

Moody's counterparty risk assessment (CRA), launched in March, captures the probability that a bank will default on its derivatives obligations. So far the CRAs for US and European banks have assumed derivatives counterparties to a stricken bank are less likely to lose money than their senior unsecured debt holders, based on assumptions that bonds will be subordinated to derivatives under new resolution frameworks, and that regulators are unlikely to bail-in derivatives anyway.

Since Moody's announcement, both Fitch and DBRS have confirmed they are considering de-linking ratings for senior unsecured and derivatives exposures in their ratings frameworks based on similar arguments.

In the Risk.net poll, 87% of respondents believe the risk that losses will be inflicted on swap counterparties during the resolution of a big bank is low. However, 11% say the risk is high, and that losses will not be limited to bonds. Just 4% believe the risk is moderate and will differ on a case-by-case basis.

So far, Moody's CRAs have placed swap exposures one to two notches above the senior unsecured debt rating, which traditionally was used as the reference point for derivatives contracts.

Derivatives end-users, which often have minimum ratings requirements for counterparties, have been hesitant to accept Moody's new higher CRA, due to uncertainty around how resolution frameworks will work in practice. However, if the practice becomes more widely accepted, and other ratings agencies follow suit, some say this could help legitimise the methodology.

"Moody's has come up with this analysis, but it is just one agency. I don't know that it's accepted across the industry that derivatives ratings should be higher than deposit ratings. Unless it becomes more widely accepted, it's a bit difficult to pitch this to clients and decision-makers," said Mark Ryan, senior derivatives and counterparty risk manager at Aviva Investors in London, speaking to Risk.net last month.

Derivatives technically can be bailed in under EU and US resolution frameworks, however the potentially disruptive knock-on effects of doing so means regulators may choose to exempt these exposures.

European regulators say they do not intend to exclude derivatives, and are drawing up a framework for the close-out and valuation of derivatives for the purpose of bailing them in.

That may be easier said than done, others counter, as when regulators end up actually putting these rules into practice, volatile market conditions could make valuing and bailing-in derivatives very tricky.

Higher counterparty risk ratings are a particular benefit for banks involved in structured finance. A number of banks' senior unsecured ratings have fallen to a point where they have to find a replacement for themselves in swap transactions with securitisation vehicles – a very difficult and potentially costly exercise.

The CRA however could lift them back up and allow them to remain in these transactions without the whole structure suffering a downgrade. One structured finance trader says his reaction to the Moody's CRA proposals is that "Christmas has come early".

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