OREANDA-NEWS. Changes to the legal framework for a proposed new category of Italian covered bonds might allow Fitch Ratings to assign a resolution-related uplift over the Issuer Default Rating (IDR), if the bonds are deemed UCITS-compliant and bail-in exempt. However, the final rating would depend on our assessment of liquidity gaps and the creditworthiness of the underlying cover assets, which will differ from those of traditional Italian covered bonds (Obbligazioni Bancarie Garantite, or OBG).

Italy's parliament converted Decree Law 18 - (Decreto Banche) into law in April. It gives the Bank of Italy supervisory powers over a new category of collateralised bank bonds that were incorporated into Italy's legal framework for covered bonds in 2014. The new-style bonds would be dual-recourse instruments secured by assets currently not eligible for OBG cover pools, including unsecured loans to small and medium enterprises (SME) and corporate bonds. Fitch would likely rate these new-style bonds in accordance with its Covered Bonds Rating Criteria.

Public supervision is one of the conditions (along with dual recourse and the issuer being in an EU member state) for an instrument to be categorised as a covered bond under article 52(4) of the UCITS directive. The EU's Bank Recovery and Resolution Directive exempts instruments that meet article 52(4)'s conditions from bail-in. If Italian collateralised bank bonds meet this definition, they could be bail-in exempt.

Our covered bond criteria allow for an IDR uplift where fully collateralised covered bonds are favourably treated in bank resolution frameworks and exempt from bail-in tool, as is the case with OBG. The IDR, adjusted by the IDR uplift, constitutes a floor for Fitch's covered bond rating, irrespective of the level of over-collateralisation. However, other elements of our analysis point to differences between OBG and collateralised bank bonds that would determine the final rating.

The cover assets in a collateralised bank bond would probably have a shorter weighted average life than those in OBG secured by residential mortgages, limiting asset-liability maturity mismatches. But these shorter-dated cover assets are less tradeable than mortgages. A collateralised bank bond with a soft-bullet redemption profile and a maturity extension of up to 15 months may therefore not achieve the same notching differential as a Fitch-rated OBG, which typically has this structure.

Refinancing risk would be lower in conditional pass-through structures (we currently rate two conditional pass-through OBG programmes), and expected credit losses would be the major driver of breakeven OC levels. We would analyse credit risk in SME cover pools using criteria applicable to Italian SME CLOs ('Criteria for Rating Granular Corporate Balance-Sheet Securitisations (SME CLOs)').

Performance of Fitch-rated SME CLOs suggests that credit risk would be higher for collateralised bank bonds backed by SME loans. The average 'B' portfolio loss rate for a residential OBG is 1.7%, compared with a 6.6% base case loss in SME CLOs (around 33% of the securitised portfolio includes unsecured loans). This would mean higher breakeven OC for the same rating level, or limit the overall rating.