OREANDA-NEWS. Fitch Ratings says its proposal to introduce a new derivative counterparty rating (DCR) scale for banks is driven by developments in bank resolution frameworks that mean different types of bank senior creditor may be treated more favourably in a resolution process than others.

DCRs are proposed to address the vulnerability to default, due to inability to pay, of any derivative contract with third party, non-government creditors. By assigning a separate DCR, we will be able to communicate our opinion on whether the vulnerability to default facing bank derivative counterparties is broadly in line with the vulnerability to default faced by senior debt holders or whether it is meaningfully lower.

Even within the derivatives class, some counterparties (eg, those collateralised or centrally cleared) will likely be treated more favourably in resolution than others (eg, uncollateralised). Therefore, DCRs would effectively address the vulnerability to default of the highest-risk (presumably uncollateralised) counterparty exposures, whether jointly or in isolation.

Being able to treat even equally ranking creditors differently is a feature of advanced bank resolution frameworks. However, Fitch proposes that a DCR will only have the capacity to be above a bank's Issuer Default Rating (IDR) when, among other considerations, derivatives are legally preferred to senior debt and/or other senior liabilities or this is expected to occur within a typical rating horizon.

Where counterparties do not enjoy legal preference over debt, resolution authorities may still have powers to treat them more favourably than equally ranking debt in some jurisdictions, including in many EU countries following the implementation of the Bank Recovery and Resolution Directive. Fitch believes there are as yet insufficient grounds to assume authorities will routinely treat all derivative counterparties more favourably than other equally ranking liabilities. Consequently, Fitch proposes that DCRs be in line with a bank's IDR in such cases.

Initially, Fitch proposes to assign DCRs to certain banks in the EU, US, Hong Kong, New Zealand and Switzerland. In most cases they are expected to be in line with an issuer's IDR. Initially, we anticipate that only certain banks in Germany, where the IDRs are driven by their Viability Ratings, will have the capacity to be assigned DCRs above their IDRs because of senior debt subordination laws that will be implemented from 2017.

In late 2015, France published a proposal to introduce a new layer of senior unsecured debt ranking junior to deposits, derivatives, structured notes and senior debt that is not explicitly stated as being part of the new senior debt layer. Because of the clear protection afforded to derivative counterparties, Fitch believes that the buffers of such debt securities could also help French banks achieve DCRs above their IDRs (subject to sufficient issuance volume) over time. The same is true of Spanish banks should they issue buffers of 'tier 3' debt.