2010/08/06

(Editor's notes: These criteria have been superseded by the article titled " TRC Financial Services Sector Issue Rating Criteria," published on November 29, 2011)

1. Taiwan Ratings Corp. (TRC) is refining its issue rating criteria to provide guideline on the issue rating of financial services sectors (including banks, securities firms, insurers, finance companies, and financial holding companies.) This article illustrates how TRC will assign issue ratings on its TRC scale. This article is related to Standard & Poor's Ratings Services criteria articles, "Hybrid Capital Handbook September 2008 edition," published on Sept. 15, 2008, and "Standard & Poor's Approach To Rating Bank Securities," published on March 19, 2004.

SCOPE OF THE CRITERIA

2. TRC is refining its issue rating criteria to provide guideline on the issue rating of bonds issued by financial services sectors. The criteria describes how, for obligations issued by financial services sectors, issue ratings may be equivalent to or notched down from the counterparty credit ratings as a result of various analytical considerations.
   
3. These criteria are related to only long-term issue ratings on the TRC scale and do not affect any Standard & Poor's (S&P) global scale ratings assigned to Taiwanese issuers. The notching process will be based from the issuer rating of TRC scale ratings, rather than S&P global scale ratings. Moreover, these criteria do not address short-term ratings or other non-TRC scale ratings.
   

IMPACT ON OUTSTANDING RATINGS

4. This criteria refinement will not result in rating actions on current outstanding debt and hybrid issues.
   

EFFECTIVE DATE AND TRANSITION

5. The refined criteria are effective immediately.

METHODOLOGY
Rating The Issue

6. In the financial services sectors (including banks, securities firms, insurers, finance companies, and financial holding companies), Taiwan Ratings Corp. (TRC) assigns two types of credit ratings-one to issuers and the other to individual issues. The first type is called a counterparty credit rating (CCR). It is our current opinion of an issuer's ability and willingness to meet its financial commitments on a timely basis. In contrast, while issue ratings address timeliness, they also address the relative ranking in bankruptcy and deferral risk on instruments where this is allowable.
   
7. In Taiwan, the issue ratings are assigned to conventional debt issues (including senior unsecured debt and subordinated unsecured debt) and hybrid capital instruments. Most types of hybrid capital instruments afford equity benefit to issuers by having ongoing payment requirements that are more flexible than interest payments associated with conventional debt, and by being contractually subordinated to such debt. Obviously, these characteristics make the instruments riskier for investors than debt. In assigning issue ratings to hybrid capital issues, we seek to assess the incremental risks associated with the issue in terms of payment timeliness and principal recovery compared to the CCR and to nondeferrable conventional debt. We reflect these risks in the ratings of hybrid capital issues by assigning them ratings that are "notched down" from the CCR. Owing to the unpredictable nature of some of the risks to which hybrid capital issue ratings are subject, the ratings are potentially more volatile than the ratings on conventional debt issues. In certain circumstances, where a bank is experiencing deteriorating credit quality, we may decide to widen the gap between the CCR and hybrid capital issue rating.
   
8. We also utilize this framework across the rating spectrum. In the case of highly rated issuers, the prospect of financial distress is, by definition, extremely distant. Still, issue ratings reflect our relative assessment of how different instruments in the issuer's capital structure might fare, should the downside case materialize. Some highly rated issuers have argued that in their particular cases, the risk of deferral is so remote that it should not be reflected in a lower issue rating than for subordinated debt. If we accepted this argument, we would not notch down for deferral risk, but we would also see little basis for recognizing equity content in the issue.

Rating The Issue: Subordination

9. Subordination adversely affects the ultimate recovery prospects of subordinated obligation holders in a bankruptcy, since claims of priority creditors must be satisfied first. For issuers rated at 'twBBB-' or above, we assign a rating one notch below the CCR for issues that are subordinated (but not deferrable). In the case of issuers rated at 'twBB+' or below, we automatically rated the issue two notches below the CCR just to reflect subordination (apart from the incremental notching for deferral risk). These differentials reflect the weaker recovery prospects for subordinated debt in a bank failure. Moreover, when subordinated debt has a greater likelihood of payment default than does senior debt-either because of special features in banking law that limit the circumstances under which subordinated debt can be paid or because of covenants in the subordinated debt that establish capital or earnings tests that must be met before payment can be made-ratings differentials would usually be wider.
   
10. We do not distinguish in the notching between gradations of subordination: Junior subordinated issues and senior subordinated issues are rated the same. Global experience has shown that, in bankruptcy, ultimate recoveries for different classes of subordinated instruments tend to be similar--and poor. (Likewise, other things being equal, we don't distinguish between hybrid capital issues that are cumulative and those that are noncumulative, since there is little reason to suppose recovery prospects of the two are materially different.
11. When a holding company issues debt, as is common Taiwan, the notching is relative to our CCR on the holding company, which is typically lower than the CCR on the main operating unit.

Rating The Issue: Deferral

12. Payment risk can be heightened in the case of hybrid capital issues due to:

• The right of optional deferral, where management has the option under the terms of the instrument to suspend or cancel distributions without triggering a default;
  
• Mandatory deferral, where, with the breaching of one or more predetermined triggers, the issuer is required to suspend payments; and
  
• Regulators' ability, in certain cases, to order companies to defer or cancel payments.
  

13. Our objective is to fully reflect payment deferral risk in hybrid capital issue ratings, whatever the potential driver of the deferral. As deferral becomes an increasingly likely prospect, the gap between the CCR and the hybrid capital instrument would widen to reflect the heightened risk of deferral.

Optional deferral

14. We assume that issuers will be loath to exercise their right of optional deferral, given the negative reaction this evokes among investors and hence the ramifications it can have for the issuer's future access to capital markets. Deferral risk is heightened when the issuer faces increased prospects of financial distress, such that management's reluctance to defer may ultimately be overcome in favor of the need to conserve cash. As referred to above, the "pressure points" may differ for different types of issuers, meaning the consideration of deferral may come at earlier or later stages in the course of credit deterioration. One danger sign is when a company curtails or eliminates its dividend on common stock: This is sometimes a precursor to a deferral on equity hybrids.

Mandatory deferral

15. Triggers for mandatory deferral vary. Some consist of earnings-, cash flow-, or capitalization-based financial ratio tests; others refer to the issuer's incurrence of a loss during a defined period or the failure to meet specified minimum regulatory capital requirements. Still others tie the payment of the distribution on the equity hybrid directly to the company's payment of the common stock dividend.
    
16. Obviously, the payment deferral risk for the hybrid capital issue investor is higher when it would take only a minor and temporary shortfall in profitability to cause the deferral, for example. On the other hand, if it would take circumstances so dire for the trigger to be breached that the issuer would likely be on the brink of bankruptcy, then the payment risks for the hybrid capital issue investor would not be materially different than they would be for debt holders.

Regulatory deferral

17. In some regulated financial services sectors, regulators have the authority to direct companies to defer payments on equity hybrids based on the regulators' own assessment of what is prudent. In certain cases, banks have been ordered to defer even when they met all regulatory capital requirements. Assessing the risk of deferral in the case of a regulated company requires careful consideration of sector- and country-specific factors, including precedents of deferral ordered by the regulatory body in question. Especially important is the identification of financial measures to which the regulator is particularly sensitive.
    
18. The authority and intent of financial regulators to order deferral of payments in certain circumstances-whether or not clearly defined-means that most hybrid capital securities of regulated financial institutions can be viewed as having de facto mandatory deferral. Regulated financial institutions structure hybrids according to rules established by national regulators for regulatory capital measures. This includes the definitions of the capital ratios or performance measures that would trigger payment deferral if breached. The triggers for deferral-typically the regulatory minimum capital ratio for banks, insurers and holding companies-are usually made explicit in the covenants of the hybrid security. Less often, the trigger is not explicit in the document but is understood by both issuer and regulator.

Rating The Issue: Factoring Payment Risk Into Issue Ratings

19. In reflecting payment/deferral risk in hybrid capital issue ratings, we evaluate the different sources of deferral risk that are present and seek to assess their combined significance. Where deferral is possible but we believe the prospect of a deferral is relatively remote for the foreseeable future, we take one notch from the CCR in setting the issue rating, whether the CCR is rated at 'twBBB-' or above, or rated 'twBB+' or below (subordination will increase the notching, as explained in the prior section). A one-notch differential is the typical treatment for issues that have optional deferral alone. For example, the subordinated and optionally deferrable issue of an issuer rated 'twBBB+' would generally be rated 'twBBB-'-one notch for subordination and one notch for payment deferral risk. If the issue were senior and deferrable (a rare but not unheard of combination), the issue would be rated 'twBBB'. We take the same approach even at the highest rating levels. (Note that a subordinated and deferrable issue of a 'twAAA' rated issuer is typically rated 'twAA'. Because there is no 'twAAA-' rating in our rating scale, 'twAA' is two notches below 'twAAA'.)
    
20. When we have heightened concerns that the issuer may defer-whether due to the exercise of its right to defer optionally, the breaching of a mandatory deferral trigger, or the exercise of a regulator's prerogatives-we increase the gap between the CCR and the issue rating. We do not impose any arbitrary limit on the size of the gap. So, in an extreme example, if the CCR of an issuer were rated at 'twBBB-' or above, but we believed that there was a substantial risk that the payment on the issuer's hybrid securities could be deferred within a few quarters, the issue would have rated at 'twBB+' or lower level. On the other hand, if the issuer faced the immediate prospect of financial distress, yet we believed management remained determined-for whatever reason-not to exercise the right to optionally defer, we could, at least in theory, narrow the notching for deferral risk.
    
21. Combinations of different forms of deferral may or may not increase deferral risk. For example, if an issue has mandatory and optional deferability and the mandatory triggers are defined so that they could be breached without there necessarily having been fundamental erosion in the issuer's credit quality, then the risks to investors would be greater than if there were optional deferability alone. The same would be true if the triggers were more reflective of fundamental credit quality, but could be breached before the point where the issuer would contemplate optional deferral. In either of these cases, a lower issue rating would be warranted than if there were optional deferability alone. In these circumstances we generally add to the gap between the issue rating and the issuer credit rating. On the other hand, if the mandatory trigger were sufficiently remote that we believed it would be unlikely to be breached before the company would otherwise have optionally deferred, then we would not take away additional notches for the mandatory deferability compared to what would be appropriate for the optional deferability alone.
    
22. If a mandatory deferral trigger is defined in such a manner that we believed the trigger would always be breached before the company would otherwise consider deferring optionally, and if the company is legally required to issue common shares immediately upon the breach of the trigger, then we could conclude that deferral risk had been effectively eliminated, and not notch down for deferral risk.
    
23. In the case of regulated financial institutions, explicit mandatory deferral triggers do not add to deferral risk stemming from regulation if-as is generally the case-the triggers just replicate the capital standards that a regulator applies in determining whether to order a deferral. Also, in the case of banks, we consider it particularly unlikely that a company would exercise unilaterally its right to defer optionally. Moreover, we would generally presume that bank regulators would act preemptively to force banks to raise capital (or divest some activities) to prevent regulatory capital guidelines from being breached. Thus, in most instances we take away only one notch for deferral risk in rating hybrid capital issues of banks rated 'twBBB-' or above, even where there is a combination of optional deferral and regulatory deferral risk.

Rating The Issue: Default And Distress

24. The definition of our 'twC' long-term issue credit rating applies to issues on which cash coupon payments have been deferred or eliminated as permitted under the terms of the issue. And on the other hand, the issuer is not bankrupt or insolvent and our credit rating CCR on the company is not 'D', 'SD', or 'twR'. We will assign a 'D' rating to issues that are in payment default, to issues that have been subject to a distressed exchange, or when the issuer has filed for bankruptcy or taken similar action.

Rating The Issue: Government Support

25. The policy for rating the hybrid equity securities of government-supported entities deserves particular mention. When TRC expects the government to support a government-supported entity's debt obligations but has less confidence that the support would be extended to the government-supported entity's equity hybrids, then the base for the notching of the equity hybrid issue rating is not just the CCR (which factors in the imputed government support). The issuer's stand-alone profile (absent government support factors, including extraordinary intervention and rescue) is also a relevant rating factor in these situations.
    
26. Our approach would be similar in the case of an entity whose CCR benefited from support of a strong parent, but where we doubted whether parental support would be extended to the subsidiary's hybrid capital.

RELATED CRITERIA AND RESEARCH

• Understanding Taiwan Ratings' Rating Definitions, published on www.taiwanratings.com on August 6, 2010.
  
• Principles of Corporate and Government Ratings, published on www.taiwanratings.com on August 6, 2010.
  
• Hybrid Capital Handbook September 2008 Edition, published on www.standardandpoors.com on Sept. 15, 2008.
  
• Standard & Poor's Approach To Rating Bank Securities, published on www.standardandpoors.com on March 19, 2004.

These criteria represent the specific application of fundamental principles that define credit risk and ratings opinions. Their use is determined by issuer- or issue-specific attributes as well as TRC's assessment of the credit and, if applicable, structural risks for a given issuer or issue rating. Methodology and assumptions may change from time to time as a result of market and economic conditions, issuer- or issue-specific factors, or new empirical evidence that would affect our credit judgment