How An Erosion Of Preferred Creditor Treatment Could Lead To Lower Ratings On Multilateral Lending Institutions

Primary Credit Analysts: John B Chambers, CFA, New York (1) 212-438-7344; john.chambers@standardandpoors.com Elie Heriard Dubreuil, London (44) 207-176-7302; elie.heriard.dubreuil@standardandpoors.com Contributor: Maximillian McGraw, New York

Table Of Contents
Factoring Preferred Creditor Treatment Into Our MLI Rating Analysis MLIs' Advantage Over Commercial Lenders Could Deteriorate Weakening Preferred Creditor Treatment Could Affect MLI Ratings In Different Ways End Notes And Related Research

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How An Erosion Of Preferred Creditor Treatment Could Lead To Lower Ratings On Multilateral Lending Institutions
Preferred creditor treatment (PCT) is an important element in Standard & Poor's Ratings Services' ratings on multilateral lending institutions (MLIs). PCT rests on an assumption regarding sovereign borrowers' future behavior. PCT positively affects MLIs' asset quality and risk-weighted capital ratios and, therefore, MLIs' creditworthiness. Should we come to believe that our assumption that MLIs will be paid more punctually than commercial or bilateral creditors will no longer hold, we could lower our MLI ratings. (Watch the related CreditMatters TV segment titled, "How An Erosion Of Preferred Creditor Treatment Could Lead To Lower Ratings On Multilateral Lending Institutions," dated Aug. 26, 2013.) Overview Our assumption about preferred treatment of multilateral lending institutions (MLIs) by sovereign borrowers is an important element in our MLI ratings. If sovereign borrowers were to begin treating MLI and commercial creditors similarly, MLI ratings could fall.

Priority of payment in the event of a sovereign default arises in the context of debt sustainability. A government can stabilize its domestic debt burden in four ways: It can raise its primary fiscal balance--that is, the budget balance before the payment of interest--by cutting expenses or raising revenue. It can raise its sustainable economic growth potential, largely through pursuing policies that improve productivity. It can inflate away a portion of the debt. (1) It can obtain debt relief, either through repudiation or restructuring. Standard & Poor's sovereign ratings address first and foremost our view of the likelihood that a government will adjust its commercial debt burden through the fourth avenue. Up until now, sovereigns have been more likely to reschedule or default on their commercial debt than their debt owed to MLIs. (2) However, debt relief can come either from commercial or official creditors (3) or both. Last year, Standard & Poor's revised its criteria for rating MLIs and other supranational institutions (see "Multilateral Lending Institutions And Other Supranational Institutions Ratings Methodology," published on Nov. 26, 2012). The criteria outline how our expectations regarding PCT affect our ratings on MLIs. Historically, MLIs have had lower default rates and higher recovery rates in sovereign lending than commercial lenders have had. The reason for this is that MLIs have been exempt from participating in sovereign debt rescheduling coordinated by the Paris Club of bilateral creditors, whereas commercial lenders often have not (under the principle of "comparability of treatment"). Similarly, in a distress scenario, sovereigns often will service debt owed to MLIs, even while defaulting on commercial debt, because sovereigns expect MLIs will offer additional financing throughout the period of distress even when

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commercial markets have closed. When sovereigns do default to MLIs, these defaults are usually cured before commercial debt arrears because such clearance is usually a condition of resumed access to funding from the International Monetary Fund. Although international treaties establishing the MLIs often contain clauses asserting seniority of their claims, (4) we believe that the PCT afforded to an MLI is rather a function of the importance of its policy role and depends, in practice, on the decision of the individual defaulting sovereign. (5)

Factoring Preferred Creditor Treatment Into Our MLI Rating Analysis

PCT is a factor in two parts of our MLI rating methodology. It is one of four components of our assessment of policy importance, which, along with governance and management expertise, determines an MLI's business profile. PCT also affects our calculations of an MLI's risk-adjusted capital (RAC). In our calculations of RAC, which is an input into our assessment of an MLI's financial profile, we use lower risk weightings for sovereign exposure than we would for that of a commercial bank, reflecting our expectations of both a lower default rate and higher recovery in the event of default. (6) In addition, we specify higher expected recoveries when adjusting our ratio for concentrations: Our assumptions about an MLI's loss given default used to compute our sovereign single-name concentration add-on are based, in part, on our view on how a sovereign borrower will treat an MLI when it exits default vis--vis its commercial lenders and investors (see "Into The Weeds Of The Revised Multilateral Lending Institutions Criteria," published Dec. 19, 2012). The combination of an MLI's business profile and its financial profile determines its stand-alone credit profile. For MLIs that have eligible callable capital, the issuer credit rating under the criteria can be higher than the stand-alone credit profile--usually one or two notches--if the callable capital materially improves the RAC ratio. (Callable capital refers to the portion of the MLI's capital subscriptions that is not paid-in but is committed by each shareholder, generally only in the event it is required to prevent a default on an MLI's debt or under its guarantee.) PCT also carries over into our RAC ratio calculations that include eligible callable capital. The RAC ratio with callable capital generally adds callable capital from governments that we rate at least as high as the MLI to the numerator of the ratio, while keeping the denominator (risk-weighted assets) unchanged.

MLIs' Advantage Over Commercial Lenders Could Deteriorate

Although most rated MLIs have a better historical track record of sovereign lending than commercial creditors do, (7) this advantage may diminish over time. Portugal (8), Ireland (9), and Greece (10) all received maturity extensions and coupon reductions of some debt from supranationals, while only Greece defaulted to commercial creditors under our definition of the term. (11) The supranationals that granted this debt relief were the European Financial Stability Facility (EFSF) (12) and the European Financial Stability Mechanism (part of the EU). (13) This granting of debt relief did not affect our ratings on the EU and EFSF. Our criteria for the EFSF do not rely on our expectation of PCT, but more on its institutional arrangement with shareholders, involving over-guarantee mechanisms. (14) On the other hand, not only did the European Investment Bank (15) enjoy preferred creditor treatment on its loans to Greece, but the bank and its subsidiary, the European Investment Fund (both of which we analyze as MLIs), also were allowed to swap their treasury holdings of Hellenic Republic bonds before the sovereign's debt exchange to avoid taking a haircut. Both institutions received new Hellenic Republic bonds that were exempt from the exchange, and we understand that

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How An Erosion Of Preferred Creditor Treatment Could Lead To Lower Ratings On Multilateral Lending Institutions

they have been serviced to date on time and in full.

Weakening Preferred Creditor Treatment Could Affect MLI Ratings In Different Ways
If sovereign borrowers' greater willingness to service their MLI debt were to lessen in the future, that potential change in the priority of payment could affect MLI ratings through different channels. Such distinctions usually only arise in distress, such as when a commercial default has occurred and the sovereign continues to honor MLI debt. In distress, even if the MLI debt is current, our assessment of sovereign risk would be higher, implying, all else being equal, lower RAC ratios because the risk weightings charged to the MLI assets increase as the ratings decline. If a sovereign borrower has ceased paying both its commercial and MLI debt, then the MLI will--usually after six months--have to reverse the related recognized but not received interest income and place the loan in nonaccrual status. (16) These steps would reduce earnings and, with them, the MLI's capacity to generate capital internally, also potentially influencing our assessment of MLI capital adequacy. Such incidents could also lead Standard & Poor's to reevaluate its forward-looking view of PCT. For policy importance assessments at the cusp of a lower category, a less constructive assumption about PCT could entail a lowering of an MLI's business profile. However, a reappraisal of PCT likely would have a greater impact on an MLI's RAC ratio. Weaker PCT assumptions would lead to higher risk weightings for sovereign exposure and higher assumptions for loss given default. If a lower RAC ratio falls into a lower band, (17) potentially leading us to revise downwards our assessment of capital adequacy, we could mark down an MLI's financial profile. MLIs for which we had assumed greater PCT would be affected more than those for which we had assumed less. (18) Changes in assumptions on PCT alone, setting aside the impact on an MLI's financial condition from sovereign debt distress, could lead Standard & Poor's to lower an MLI's stand-alone credit profile by as much as a category (see table 1). Depending on the characteristics of the MLI's callable capital, we could lower our rating on the institution by an equal amount (see chart).
Table 1

Pro Forma Impact Of No PCT Assumption On Capital Adequacy

--With PCT---Without PCT-Extremely strong Very strong Extremely strong Very strong Strong 8 7 4 6 1 2 Strong 1 4 3 1 1 Adequate

MLIs with capital adequacy assessed as at least "strong." As of Aug. 26, 2013.

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How An Erosion Of Preferred Creditor Treatment Could Lead To Lower Ratings On Multilateral Lending Institutions

We do not expect the PCT of the MLI asset class to erode. If we did, depending on the strength of that view, we would have either lowered ratings on the affected institutions already (19) or revised our rating outlooks on them to negative. Most of the ratings currently have stable outlooks. (20) However, we see PCT as an important element that distinguishes the credit quality of the MLI asset class from that of the asset class of large commercial banks. We rate large commercial banks, on average, one or two categories lower than their official brethren.
Table 2

Multilateral Lending Institutions Cited In This Article

Institution Caribbean Development Bank European Central Bank European Financial Stability Facility European Investment Bank European Investment Fund European Union Stand-alone credit profile Long-term issuer credit rating Outlook aaN.A. N.A. aa aa+ N.A. AA AAA AA+ AAA AAA AAA AAA NR Negative Stable Negative Negative Negative Negative Stable NR

International Bank for Reconstruction and Development aaa International Monetary Fund NR

N.A.--Not applicable. NR--Not rated. Ratings as of Aug. 26, 2013.

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How An Erosion Of Preferred Creditor Treatment Could Lead To Lower Ratings On Multilateral Lending Institutions

End Notes And Related Research

(1) This strategy works if the inflation is unexpected and if the government debt is denominated in local currency, is fixed-rate, and is long-dated. For a discussion of financial repression and ratings, see "Financial Repression Would Hurt The Highest-Rated Sovereigns, But Help Those At The Bottom," Aug. 30, 2012. (2) See for example "Sovereign Defaults At 26-Year Low, To Show Little Change In 2007," chart 6, RatingsDirect, Sept. 18, 2006. (3) This article principally addresses commercial and MLI debt of a sovereign. Bilateral debt is another significant creditor class. Nineteen governments coordinate their actions regarding bilateral debt relief through the Paris Club. (4) The treaty establishing the European Stability Mechanism is, however, the only one explicitly referring to "preferred creditor status." (5) An ancillary dynamic is also at play. At the point that a default to an MLI is contemplated, a country is typically under IMF auspices already. Since the member countries of the IMF overlap with those of most MLIs, the IMF board typically will require as a condition to its own lending that MLI loans be kept current or, if in default, cured. (6) Except when a sovereign's MLI debt exceeds 75% of its total external debt. See paragraph 90 of the criteria, "Multilateral Lending Institutions And Other Supranational Institutions Ratings Methodology," published Nov. 26, 2012. (7) The historical record is more nuanced for soft-loan windows that are often part of the same group as the rated MLI. See "Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI) Status of Implementation and Proposals for the Future of the HIPC Initiative," International Monetary Fund, Nov. 8, 2011, table 5, p. 54. (8) See "Portugal Outlook Revised To Stable On European Financial Support; 'BB/B' Ratings Affirmed," RatingsDirect, March 6, 2013. Note that we have subsequently revised our rating outlook on Portugal to negative. Ratings cited in this article are as of Aug. 26, 2013. For current ratings, see "Sovereign Ratings And Country T&C Assessments," RatingsDirect, updated regularly. (9) See "Outlook On Ireland Revised To Positive On Improved Prospects For Debt Reduction; Ratings Affirmed At 'BBB+/A-2'," RatingsDirect, July 12, 2013. (10) See "Ratings On Greece Raised To 'B-/B' From Selective Default On Completion Of Debt Buyback; Outlook Stable," RatingsDirect, Dec. 18, 2012. As the headlines for Portugal, Ireland, and Greece imply, official debt relief can help ratings on commercial debt. (11) See "Greece Ratings Lowered To 'SD (Selective Default)," Feb. 27, 2012; "Greece Ratings Lowered To 'SD' (Selective Default)," Dec. 5, 2012; "Sovereign Government Rating Methodology And Assumptions," June 24, 2013; and "Distressed Sovereign Debt Exchanges: Examples From The Past And Lessons For The Future," June 28, 2011, all on RatingsDirect.

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(12) See "European Financial Stability Facility," RatingsDirect, Dec. 26, 2012. (13) See "European Union," Dec. 4, 2012. (14) We also note that the cost of carry of these loans is still positive and that their restructuring is tantamount to what occurs when one IMF program is replaced by a successor program. (15) See "Ratings On European Investment Bank Affirmed At 'AAA/A-1+' Following Criteria Revision; Outlook Negative," Dec. 5, 2012. (16) For example, the International Bank for Reconstruction and Development, member of the World Bank Group, placed its loans to the Islamic Republic of Iran in nonperforming status on July 16, 2013. (17) See mapping of RAC ratio to assessment of capital adequacy in table 6 of the criteria, "Multilateral Lending Institutions And Other Supranational Institutions Ratings Methodology," published Nov. 26, 2012. (18) In addition, loans to sovereigns with a low share of MLI debt to total government external debt would be more affected than loans to sovereigns with a high share. (19) See for example "Caribbean Development Bank Long-Term Rating Lowered To 'AA' Under Revised Criteria; Outlook Is Negative," RatingsDirect, Dec. 12, 2012. (20) And those that have negative outlooks do so for reasons other than our views on PCT.

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