Moody’s rating of first NVCC shares could establish a precedent

“This incremental loss absorption feature is credit positive for holders of senior securities of RBC, as a layer of loss absorbing securities will reduce the risk of losses incurred higher in the capital hierarchy if the bank gets into financial distress,” Moody’s says.

It also notes that this represents the first issuance of “contractual non-viability preferred securities” in Canada, noting, “we expect this issuance could establish a precedent for future NVCC preferred shares in the Canadian market — similar to what occurred with the structure [TD Bank] established in 2000 for innovative Tier I capital that held constant for several years.”

Moody’s says that it expects the market for Canadian Basel III-compliant additional Tier 1 preferred shares to eventually reach in excess of $20 billion, which represents 1.5% of the largest Canadian banks’ risk weighted assets (RWAs). It notes that OSFI guidelines will require all domestic systemically important banks to maintain minimum common equity tier 1 of 8%, plus an additional 1.5% for RWAs when fully phased-in.

Not all of the additional capital will be in contractual non-viability preferred shares, it notes, “as banks will likely hold a ‘buffer’ of [common equity] which will count towards the total 9.5% requirement. However, to the extent that NVCC preferred shares can be issued more cheaply than common stock, we expect that banks will likely optimize the most cost-effective Tier I securities they can while maintaining prudent common equity levels,” it says, adding that this supports its expectations for a pickup in preferred share issuance in the coming year as the banks seek to refinance upcoming preferred share redemptions.

Moody’s is rating RBC’s new instrument Baa3 (hyb), noting that the rating is positioned four notches below the bank’s adjusted baseline credit assessment. It notes that this is one notch below existing Canadian non-cumulative preferred shares “to capture the potential uncertainty related to the timing of loss absorption”; and, that this notching is in line with Moody’s standard notching guidance for contractual non-viability preferred securities.

It also notes that the contractual terms of the NVCC preferred shares incorporate a provision allowing the issuer to amend the terms of the security, subject in some cases to regulatory approval and in all cases to preferred shareholder approval. “We view this investor protection as a credit positive because it ensures that any future amendments to the terms will not be made to the detriment of the security holders,” it says.