Rating Contingent Capital Securities


FSOC released its report on contingent capital on July 18, entitled “Report to Congress on Study of a Contingent Capital Requirement for Certain Nonbank Financial Companies and Bank Holding Companies”.  The report places a particular focus on the important feature of contingent capital for “generating additional common equity capital to strengthen a firm’s ability to absorb losses on its balance sheet (while it is a going concern).” 

The FSOC report suggests a potential role for rating agencies in contingent capital market on the basis of investors’ view that positive rating opinions would be required for developing a deep and liquid market.  To this end, this article provides a brief comparison of analytical approaches for rating contingent capital securities by the Big 3 rating agencies and discusses the essential analytical requirement for rating contingent capital securities.

What Is Rated?

Traditional risk exposures of fixed-income securities are default risk and risk of principal loss by subordination in liquidation.  Contingent capital is by nature hybrid capital with loss absorbing features such as equity conversion or principal write-down.  Therefore its risk exposure is “non-default risk”, which is the risk of principal loss outside liquidation.  As the name of going concern or gone concern contingent capital implies, the risk of contingent capital securities is the issuers’ ability to continue as going concern.  Going concern risk as an economic, accounting concept is best represented by probability of insolvency.

In Moody’s Guidelines for Rating Bank Hybrid Securities and Subordinated Debt, dated November 2009, it is observed that “contrary to historical precedent, recent events have shown that hybrid “default” probability now is clearly higher than for bank senior debt, and losses could occur in a restructuring outside liquidation through coupon suspension, principal write-downs, good bank/bad bank structures, and distressed exchanges.”   In other words, credit risk has essentially evolved from being single dimensional to multidimensional to include non-contractual risks such as reversal of creditor seniority and accounting risks such as mark-to-market CVA volatility losses.  The statistical gap between “pure” default risk measurement and going concern risk measurement is shown in Table 1. 

Table 1

Statutory   GCO calibration

Going   concern







Gone   concern

Gone   concern

Credit   rating








More   likely than not

Substantial doubt

Annual   default rate










Source: Fitch Global Corporate Finance Average Cumulative Default Rates: 1990-2011.  PCAOB Investor Advisory Group Going Concern Survey dated 28 March 2012. 


Moody’s has not published rating criteria for rating contingent capital securities to date.  In “Moody’s Guidelines for Rating Bank Hybrid Securities and Subordinated Debt”, published in November 2009, Moody’s states that it is likely that rating will not be assigned to contingent capital securities whose potential losses to investors are difficult to measure.  It further states that “the securities most likely to fall into this category are those that contractually give the issuer and/or the regulator the discretion to convert the “host” security into common equity. To the extent that there are triggers, our focus will be on whether or not they provide an objective threshold for conversion enabling an investor to reasonably measure the risk associated with conversion.”   

Moody’s said it would continue to assess its ability to rate the securities subject to fixed income characteristics.  If it is decided that certain types of securities can be rated, Moody’s will focus analysis on the ability of the “host” to absorb losses as a “going concern”, the probability of conversion, and the loss severity given conversion based on the conversion ratio.   To date, its position on rating contingent capital has not changed since publication of the 2009 Guidelines, which is included in “Moody’s Consolidated Global Bank Rating Methodology”, published on 29 June 2012. 

It appears that Moody’s fully recognizes the difficulties of going concern assessment of banks.  It remains to be seen how Moody’s further develops the concept of “hybrid default” and incorporates the analysis of risk of principal loss outside liquidation in contingent capital rating methodology.     


Fitch published their contingent capital rating methodology, entitled “Rating Bank Regulatory Capital and Similar Securities” in December 2011.  Fitch further published a rating criteria report entitled “Treatment of Hybrid in Bank Capital Analysis” on 9 July 2012 and is expected to republish the report by the end of 2012 by merging it with the December 2011 report.  

Risk of contingent capital securities is defined as “hybrid non-performance”, including coupon omission or deferral, principal write-down or conversion.  Fitch rates contingent capital securities, subject to specific features, by notching down from a rating anchor – a bank’s viability rating (VR).  In “Definitions of Ratings and Other Forms of Opinion”, dated April 2012, VR is defined as to represent Fitch’s view of the intrinsic creditworthiness of an issuer, absent from external support and constraints.  As such, VRs represent the capacity of the bank to maintain ongoing operations and to avoid failure.  Notching is based an end-game scenario, which Fitch assumes to be resolution or liquidation, and is divided into two parts: notching for loss severity and non-performance risk.  The two components are additive and both are relative to the same anchor.  

In addition, Fitch uses going concern assessment (GCA) scores for going concern assessment of issuers of future flow securitization, including bank issuers.  The GCA score methodology is found in “Future Flow Securitization Rating Criteria”, dated 19 June 2012.


S&P published their contingent capital rating methodology, entitled “Bank Hybrid Capital Methodology and Assumptions” in November 2011.  Similar to Fitch’s approach, ratings for contingent capital securities, subject to specific features, would be notched down from anchor ratings, either stand-alone credit profile (SACP) or ICR.  

Does Notching of Contingent Capital Securities Make Sense?

Notching in the context of credit rating requires three elements.

  1. An ultimate objective, such as liquidation upon bankruptcy that would activate distribution of liquidation value among creditors according to subordination.
  2. Clearly defined, legally enforceable subordination of risks based on contractual relationship, without any possibility for undefined risks, such as a catastrophic litigation, to have priority over or pari passu rights to senior creditors.  Otherwise notching would not have any analytical meanings.
  3. Clearly defined, legally enforceable trigger event, such as default or cross default.

The follow analysis shows that notching of contingent capital securities in the context of credit rating may not be possible.

  1. The ultimate objective would be resolution when an issuer develops “substantial doubt” for continuing as a going concern, or when the issuer has become a gone concern.  The resolution process would reallocate going concern value among stakeholders by either converting debt to equity (principal conversion) or extinguishing contractual claims of debts on going concern value (principal write-down).  Given analytical ambiguity in determining going concern value at time of resolution activation and what constitute going concern vs. gone concern, notching of contingent capital securities against a credit rating anchor would not make much analytical sense.  In addition, significant non-contractual, accounting risks, such as mark-to-market CVA volatility losses, could potentially create more losses outside resolution than loss of principal in resolution.  According to BIS, realized CVA volatility losses during the 2008 global crisis were twice as much as default losses.  
  2. Fitch in its December 2011 rating criteria report states that “it is not practical within the limitation of Fitch’s 19-point rating scale to capture every loss severity or non-performance risk nuance.”  Given that the lowest rung of rating scale, “CCC”, is calibrated at 24.5%, it is obvious that credit rating scale would either have to expand significantly, possibly to the letter of “M”, or the underlying implied probability of “hybrid default” or “hybrid non-performance risk” for current credit rating scale would have to increase significantly in order to close the statistical gap in Table 1.  
  3. Clearly defined, legally enforceable going concern or gone concern triggers remain elusive.  Going concern trigger has been a main challenge in the accounting and audit domain for decades and has not been resolved to date.  In the absence of a clearly defined, legally enforceable trigger, calibration of probability of conversion or equitable reallocation of going concern value would be difficult to achieve.  


The risk exposures of contingent capital securities are essentially going concern risk, or insolvency risk, which as an economic, accounting concept must be analyzed differently from credit risk, which is a legal concept.  In this regard, the structure of contingent capital securities has transcended the traditional realm of single dimensional credit risk and subverted the liquidation-centric notching practice of credit rating discipline.  Therefore, rating of contingent capital securities cannot be a simple notching exercise.  

In order to capture all risks of contingent capital securities and develop a robust rating approach, the following features must be present in rating of contingent capital securities.

  1. Since the risk exposure of contingent capital securities is going concern risk instead of credit risk, it must be redefined as such.  
  2. Trigger must be unequivocally defined with legal enforceability without any uncertainty or ambiguity; cannot be manipulated and create basis risk.  
  3. Analytical clarity in accounting distinction between what constitute going concern and gone concern.  The debate on this issue continues as of today at both FASB and PCAOB.




About Simon Hu

Simon Hu is an independent economist who recently developed a revolutionary economic theory called going concern economics that would resolve the current global economic malaise and political chaos.
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