OSFI Loosens Rules on Innovative Tier 1 Capital

OSFI has released Advisories on Innovative Tier 1 Instruments.

I have not yet reviewed the intricacies of the advisories, but it appears that the the draft advisory I thought was so appalling has been adopted in toto. Canadians can be, er, proud to declare that we are basically the only jurisdiction that allows cumulative Tier 1 Capital.

Update, 2008-12-15 From the Advisory on Innovative Tier 1 Instruments:

A new form of loan-based innovative instrument will now qualify for inclusion in Tier 1 capital. Under this structure, the special purpose vehicle (SPV) issuing the innovative instrument will issue a 99-year security to investors and the SPV will use the proceeds from such issuance to acquire an inter-company debt instrument from the FRE with maturity conditions that are the same as the public issue. Under specified circumstances to maintain cash resources in the FRE, and as a result of contractual obligations between the investors, the SPV and the FRE, the investors in the SPV securities will receive directly issued preferred shares of the FRE to satisfy interest and/or principal payments on the innovative instrument.

the risk premium (over the risk-free rate) reflected in the dividend rate on the Tier 1-qualifying preferred shares issued pursuant to an automatic conversion must be established at the time the innovative instrument is issued and must not exceed the risk premium (over the risk-free rate) reflected in the dividend rate of comparable shares as at that date (i.e. upon the original issuance of the innovative instrument).

innovative instruments can now include securities which mature in 99 years. These, however, will be subject to straight-line amortization for regulatory capital purposes beginning 10 years prior to maturity.

An innovative instrument is now permitted to be “share cumulative” where under specified circumstances to maintain cash resources in the FRE, and as a result of contractual obligations between the investors, the SPV and the FRE, deferred cash coupons on the innovative instrument become payable in Tier 1-qualifying perpetual preferred shares of the FRE2, subject to the following requirements:
  • Cash coupons on the innovative instrument can be deferred at any time, at the FRE management’s complete discretion, with no limit on the duration of the deferral, apart from the maturity of the instrument.
  • The preferred shares issued by the FRE will initially be held in trust and will only be distributed to the holders of the innovative instrument to pay for deferred coupons once the cash coupons on the innovative instrument are resumed or when the innovative instruments are no longer outstanding (e.g. maturity of the innovative instrument, conversion of innovative instrument into preferred shares of the FRE, etc.).

And, from the Innovative Tier 1 and Other Capital Clarifications:

The adoption and current interpretation of the Accounting Standards Board’s Accounting Guideline 15 (AcG 15) results in Canadian “loan-based” innovative Tier 1 SPVs no longer being consolidated with the sponsoring FRE that owns the common securities and the interpretation also results in certain Financing Entities used by FREs to issue Tier 2 capital instruments no longer being consolidated with the FRE.

OSFI has determined that:

  • For “loan-based” innovative Tier 1 instruments, the SPV will no longer be required to be consolidated as a precondition for the public issue to be treated as innovative Tier 1 capital of the FRE.


Principle #9(b) under the Interim Appendix to Guideline A-2 (Banks/T&L/Life), “Principles Governing Inclusion of Innovative Instruments in Tier 1 Capital” states that “the main features of innovative instruments, including those features designed to achieve Tier 1 capital status (for example, the triggers and mechanisms used to achieve loss absorption), must be publicly disclosed in the FRE’s annual report to shareholders.”
This disclosure requirement is even more important now that capital will include innovative Tier 1 capital instruments that do not appear on the FRE’s balance sheet. In future, regulatory approvals for the issuance of loan-based innovative Tier 1 instruments will be conditional on acceptable plans for adequate disclosure of the main regulatory capital features of these instruments in the annual report to shareholders.

So bank balance sheets just got even more difficult to understand. If the SPV is not consolidated, then something that looks like a loan will magically count as Tier 1 Capital. I don’t know who’s at fault here, but I don’t like it!

A FRE has recently approached OSFI regarding the inclusion of a “make-whole” provision in the terms and conditions of a Tier 2-qualifying instrument issued into a foreign market. The provision states that, if tax laws change such that the FRE is required to withhold or account for any present or future tax, assessment or governmental charge by any Canadian tax authority, the FRE will pay noteholders an additional amount needed so that the net amount received by the noteholders, after such a withholding, will equal the amount that would have been received had no such withholding been required.

OSFI has assessed this provision and determined that it will permit such “make-whole” provisions in Tier 2 capital.

Whoosh! That came out of the blue!

4 Responses to “OSFI Loosens Rules on Innovative Tier 1 Capital”

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