Moody's Investors Service has today downgraded by one notch Bank of Ireland's (BOI) deposit ratings to Ba2/NP from Ba1/NP and senior debt ratings to Ba3 from Ba2, prompted by the concurrent lowering of the bank's baseline credit assessment (BCA) by two notches to b1 from ba2. In line with the downgrade of BOI, Moody's has also downgraded the deposit ratings of BOI's subsidiary ICS Building Society to Ba2/NP and lowered its BCA to b1. The lowering of the BCA reflects Moody's view of the increase in risks to bondholders arising from (1) ongoing asset-quality challenges that have the potential to put pressure on BOI's capital levels beyond the expectations of the Prudential Capital Assessment Review (PCAR) undertaken by the Irish regulator in 2011. These pressures are at least partially reflected in the adjustments required by the Central Bank of Ireland (CBI), following its Balance Sheet Assessment (BSA) of BOI; and (2) the closely-related risk for BOI's bondholders stemming from the prospect of the stress test that will be undertaken by the European Central Bank (ECB) in 2014. While the design of the stress test remains unclear and its result difficult to anticipate, banks such as BOI with poor quality lending books, relatively low levels of provisions and poor profitability are at relatively greater risk of 'failing' the test. Any resulting material capital shortfall, if it cannot be remedied by BOI or its shareholders within a certain (still undefined) period, directly raises the risks for BOI's bondholders. At the same time, Moody's believes that BOI's increasingly visible return path to sustainable profitability should help it to offset some of these asset quality and capital pressures, while the potential for the bank to tap the private capital markets -- to which it currently has some access -- for equity injections should also be a further protection for bondholders. The moderate expectation of support from the Irish government leads to a one-notch uplift for BOI's senior unsecured debt ratings. In line with previous government actions to support depositors, Moody's continues to incorporate a higher degree of support likelihood for BOI's deposits, resulting in two notches of rating uplift from the standalone BCA. RATINGS RATIONALE --- ONGOING ASSET-QUALITY CHALLENGES POSE DOWNSIDE RISKS The continued rise and high level of non-performing loans illustrates the extent of BOI's asset quality problems in its Irish lending book and the ongoing downside risk this poses for BOI's capitalisation. The data as of June 2013 suggest that over 14% of mortgage loans in Ireland , about 23% of the Irish non-property SME and corporate book and, overall, 19% of the lending book (including the UK ) is non-performing. Moody's takes some comfort from tentative signs that the build up of new NPLs is weakening. However, even if these positive signs were to persist, the expected loss in BOI's balance sheet could still increase in view of regulatory pressure to increase still further the provisions, which remain low by comparison with BOI's peers in Ireland and some other countries facing similar challenges such as Spain. The results of the BSA reflect this risk because under the terms of the BSA published by BOI, but which it currently contests, BOI would have to set aside EUR360 million of additional impairment provisions for its Irish mortgage portfolio and EUR486 million for its property & construction, small and medium enterprises (SMEs) and corporate portfolios respectively. The bank would also have to take 547 million of additional provision to cover the additional potential updated treatment of expected loss on defaulted assets. The sum of all potential provisions would increase its coverage ratio above 50%, in line with the current system average. In addition, the bank might have to increase its RWAs by approximately EUR6.8 billion . --- ADEQUATE CAPITALISATION UNDER CURRENT RULES, HOWEVER BOI STILL HAS TO PASS THE ECB STRESS TEST AND REPLACE NON-QUALIFYING CAPITAL INSTRUMENTS UNDER CRD IV Moody's is concerned that these underlying asset quality problems, reflected in the continued rise in NPLs and the low level of provisions, leave the bank in a more vulnerable position to face the stress test the ECB will conduct in 2014 as part of its comprehensive assessment of European banks. There remains considerable uncertainty surrounding the stress testing process and the key parameters it will incorporate -- for example loss rates, target capital levels, corrective windows -- which make the outcome difficult to anticipate. However, in Moody's opinion, banks such as BOI, with vulnerable lending books, relatively low provisions and poor profitability, are at relatively greater risk of 'failing' the stress test. In Moody's view the ECB's Asset Quality Review (AQR) poses a lower threat than the stress test since the ECB will likely use the data from the BSA for its comprehensive assessment in line with CBI's expectations. As a result, the rating agency believes that BOI will remain adequately capitalised under the Basel III transitional rules even after meeting all the potential requirements outlined as a result of the ECB's AQR. However, the starting point CRDIV transitional CET1 ratio will be eroded, increasing the uncertainty as to whether BOI's CET1 ratio will be deemed adequately capitalised on a stressed basis. The bank's stressed ratio would face additional pressure from the phased-in deduction for deferred tax assets that remain sizable for BOI, the deduction which will continue to have a negative impact on its fully loaded CET1 ratio. The implications of 'failing' the stress test are difficult to predict and the offsetting actions management could take correspondingly uncertain. Moody's believes that BOI's proven ability to raise equity from private investors is positive for bondholders. The bank recently placed EUR580 million of ordinary stocks to redeem preference shares held by the Irish government and the government sold its remaining stake in the banks represented in EUR1.3 billion of preference shares to private investors. Nevertheless access to private capital following the stress test cannot be taken for granted, in which case additional capital would need to be sourced elsewhere. Moody's believes that the slightly heightened risks to bondholders need to be reflected in both lower baseline credit assessment (to signal the potential for some sort of support event) and lower debt ratings (to signal the heightened risk to creditors).
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