Category: Regulation

Regulation

OSFI Disgraces Itself Again

I did not think it was possible for OSFI to bring greater disgrace upon itself than it did in the debate over a Principal Loss Absorbency Mechanism (PLAM) for insurers, which would have applied NVCC-like rules to insurer Tier 1 Capital.

But they’ve done it, by planning to become another rah-rah branch of government:

Canada’s banking regulator is working to change the way it treats some business loans, in an effort to make it more appealing for banks to lend to companies that are key to Ottawa’s plans to reshape the country’s economy.

The head of the Office of the Superintendent of Financial Institutions (OSFI), Peter Routledge, said Wednesday that the regulator is consulting with banks and life insurers “to help them help the country,” at a conference in Toronto held by Bank of Nova Scotia.

The forthcoming changes are intended to “rebalance” a highly technical set of rules by which the regulator assigns different levels of risk – known as “risk weightings” – to different types of bank loans.

Those weightings help determine how much capital a bank has to hold in reserve against its loan portfolio, which in turn shapes decisions about who gets loans and how much banks lend.

The justification for this has been reported as:

Whereas commercial lending accounted for about 60 per cent of banks’ loan portfolios in 1982, it now makes up about 25 per cent of current loan books, he said. That is partly because risk weightings on business loans are often three to four times higher than loans to households, such as a mortgage, which skews their relative profitability.

The result has been that banks in Canada and abroad have pulled back on some types of lending to small and medium-sized businesses, as well as large corporations. In the U.S., a booming private credit sector has seen investors raise vast pools of capital to make direct loans to private companies, often at higher interest rates. But in Canada, banks are still the main source of capital for many businesses.

If the trend away from business lending continues, it could constrain new economic investment and growth. OSFI’s initiative to tweak risk weightings seeks to help rebalance the mix of bank loans.

Excuse me? OSFI states that its mandate is:

Our mandate
Our purpose is to contribute to public confidence in the Canadian financial system by regulating and supervising approximately 400 federally regulated financial institutions (FRFIs) and 1200 federally regulated pension plans (FRPPs).

Our mandate is to:

ensure FRFIs and FRPPs remain in sound financial condition
ensure FRFIs protect themselves against threats to their integrity and security, including foreign interference
act early when issues arise and require FRFIs and FRPPs to take necessary corrective measures without delay
monitor and evaluate risks and promote sound risk management by FRFIs and FRPPs
In exercising our mandate:

for FRFIs, we strive to protect the rights and interests of depositors, policyholders and financial institution creditors while having due regard for the need to allow FRFIs to compete effectively and take reasonable risks
for FRPPs, we strive to protect the rights and interests of pension plan members, former members and entitled beneficiaries

I don’t see anything in there about making it easier for business to borrow money.

The only question relevant to the issue that OSFI has any conceivable business looking into is: do risk weightings reflect actual risks?

The rationale has been extended:

Banks’ lending to the defence sector, in particular, “is arguably a little low,” but in recent decades that has been more because of modest Canadian investment in defence, rather than regulatory constraints, Mr. Routledge said.

OSFI would at least consider adjusting risk weightings for defence lending – especially if new public-private partnerships are created – to encourage lenders to support Canada’s loftier spending targets for national security, he said.

“Until I see a proposal I can’t really say, but we are open for business on considering that,” he said.

It is none of OSFI’s damn business whether Canada meets loftier spending targets for national security. That’s a fiscal issue, a policy matter for government. If the banks find it more profitable to fund mortgages rather than guns, so be it: if the government wants a policy response it should make one, rather than allow some kind of back-room machination to cast a mask of respectability over the adjustment. For instance, I believe it would be good policy to cut back on CMHC mortgage guarantees, particularly portfolio insurance. The ready availability of mortgages and insurance thereof has, I think, been a major factor in skyrocketting housing prices over the past twenty years.

I want OSFI to do one job – ensure that banks and insurers are “adequately” capitalized, whatever the word “adequately” means. There is no reason for them to get into the central planning business.

Update, 2025-9-4: The logical place to start using government leverage to increase business lending would be the Business Development Bank, but sadly, they’re not doing too well:

Business Development Bank of Canada hiked provisions for expected loan losses sharply in its fourth quarter, reflecting the potential hit from U.S. tariffs on the small and medium businesses financed by the federal Crown corporation.

BDC ended its 2025 fiscal year on March 31 with a $624.3-million provision for expected credit losses on loans, according to its annual report, published on its website. That’s up from $465.6-million three months earlier.

Its level of impaired loans jumped by 86 per cent year-over-year, reaching $514.4-million. Provisions for credit losses have jumped in each of the past three years. BDC subsequently booked a $160-million provision for credit losses in the first quarter of its 2025-26 fiscal year.

BDC provides loans and advisory services to small and medium-sized Canadian businesses and makes venture and growth capital equity investments in startup and scaleup companies and third-party funds that back them. BDC also manages capital incentive programs on behalf of the government, including the Venture Capital Catalyst Initiative, a fund for financing Indigenous entrepreneurs and some COVID-relief programs for small business. It had $42.8-billion in outstanding loans on its books on June 30 and $6.4-billion in investments
…
But BDC’s financial results have disappointed. Its annual net income in each of the last three years, including $402.3-million in fiscal 2025, were the three lowest results of the past 14 years, excluding the pandemic year of 2020 when the Crown corporation posted a rare net loss. BDC also declared a $50-million dividend payable to the government in its 2026 fiscal year, down from $337-million in each of the prior two years.

Return on common equity last year was 4.7 per cent, BDC’s best performance in three years but below its 5.9-per-cent target mainly owing to the higher levels of credit loss provisions in its financing business. That compares to returns on equity that typically surpassed 10 per cent every year going back to at least 2011, except for the pandemic year of 2020, and 2017, when it was 8.2 per cent.

Contingent Capital

NVCC: “Minimum Reset Guarantee” = “Incentive to Redeem”?

I have long accepted that banks cannot offer minimum reset guarantees on their FixedResets because this is considered to be an incentive to redeem by the regulators. I’m almost certain that I saw an authoritative statement to this effect at one point and reported it here, but when I tried to find it my search was fruitless.

The OSFI Definition of Capital is quite emphatic about incentives:

The following is the minimum set of criteria for an instrument issued by the institution to meet or exceed in order for it to be included in Additional Tier 1 capital:
…
Is perpetual, i.e. there is no maturity date and there are no step-ups [Footnote15] or other incentives to redeem [Footnote16]

The footnotes read:

Footnote 15
A step-up is defined as a call option combined with a pre-set increase in the initial credit spread of the instrument at a future date over the initial dividend (or distribution) rate after taking into account any swap spread between the original reference index and the new reference index. Conversion from a fixed rate to a floating rate (or vice versa) in combination with a call option without any increase in credit spread would not constitute a step-up. [Basel Framework, CAP 10.11 FAQ4]

Footnote 16
Other incentives to redeem include a call option combined with a requirement or an investor option to convert the instrument into common shares if the call is not exercised. [Basel Framework, CAP 10.11 FAQ4]

… but I couldn’t find anything from (or attributed to) OSFI that stated that a Minimum Reset Guarantee constituted a step-up.

I did, however, find a notice from the European Banking Authority:

Question:
Article 489 of Regulation (EU) No 575/2013 (CRR) provides for the grandfathering treatment of hybrid instruments with a call and an incentive to redeem. A bank has issued a bond with a fixed coupon before the first call date and a floating rate coupon after the first call date. The credit spread of the fixed coupon as of the issuance date is the same as the margin of the floating rate coupon after the first call date, so there is no immediate step-up there. However, the floating rate coupon is floored at the level of the fixed rate coupon. Does this constitute an incentive to redeem ?
…
Final Answer:
Pursuant to Article 20(1) of Commission Delegated Regulation (EU) No 241/2014 an incentive to redeem shall mean all features that provide, at the date of issuance, an expectation that the capital instrument is likely to be redeemed. A floating rate coupon floored at the level of the initial fixed rate coupon, such as in the case described by the submitter, constitutes an incentive to redeem, as the new coupon after the first call date will always be equal or higher than the initial coupon.

So to some extent, this post is my bookmark for this little fact. But it is also a request that perhaps somebody with a better memory than mine find the reference I’m thinking of!

Contingent Capital

NVCC & Credit Suisse

OSFI has announced:

OSFI is issuing this statement to reinforce guidance around the design of the regulatory treatment of Additional Tier 1 and Tier 2 capital instruments.

Canada’s capital regime preserves creditor hierarchy which helps to maintain financial stability.

If a deposit-taking bank reaches the point of non-viability, OSFI’s capital guidelines require Additional Tier 1 and Tier 2 capital instruments to be converted into common shares in a manner that respects the hierarchy of claims in liquidation. This results in significant dilution to existing common shareholders.

Such a conversion ensures that Additional Tier 1 and Tier 2 holders are entitled to a more favorable economic outcome than existing common shareholders who would be the first to suffer losses. These capital requirements are administered by OSFI as well as the conversion of the Additional Tier 1 and Tier 2 capital instruments.

Additional Tier 1 and Tier 2 instruments are and will remain an important component of the capital structure of Canadian deposit-taking banks.

Canadians can be confident that we have a sound and effective regulatory and supervisory foundation that works to protect depositors and creditors.

And the European Central Bank teamed up with other regulators to announce:

ECB Banking Supervision, the Single Resolution Board and the European Banking Authority welcome the comprehensive set of actions taken yesterday by the Swiss authorities in order to ensure financial stability.

The European banking sector is resilient, with robust levels of capital and liquidity.

The resolution framework implementing in the European Union the reforms recommended by the Financial Stability Board after the Great Financial Crisis has established, among others, the order according to which shareholders and creditors of a troubled bank should bear losses.

In particular, common equity instruments are the first ones to absorb losses, and only after their full use would Additional Tier 1 be required to be written down. This approach has been consistently applied in past cases and will continue to guide the actions of the SRB and ECB banking supervision in crisis interventions.

Additional Tier 1 is and will remain an important component of the capital structure of European banks.

This announcement appears to be due to the treatment of AT1 instruments in the collapse of Credit Suisse:

Trading in Credit Suisse’s bonds rose sharply at the end of last week as strain in the banking sector mounted, according to official trade data.

There were two types of trades that the investors conducted: one that is set to make money, the other that is set to lose money.
…
The second trade that investors plowed into was in Credit Suisse’s roughly $17 billion of so-called AT1 bonds. This is a special type of debt issued by banks that can be converted to equity capital should they run into trouble. This made that debt inherently riskier to hold, because it carried the chance that bondholders could be wiped out. Investors saw the buying of the bonds for as low as 20 cents on the dollar as a kind of lottery ticket — a long shot, but with a big reward if it had worked out.
…
On Sunday, the Swiss Financial Market Supervisory Authority, or Finma, approved a deal for UBS to take over its smaller rival. “The transaction and the measures taken will ensure stability for the bank’s customers and for the financial center,” said a statement from Finma.

It said that the AT1 bonds would be wiped out as part of the deal, to add roughly $16 billion of equity to support UBS’s takeover.

That raised eyebrows among some investors because it upended the normal order in which holders of different assets of a company expect to be paid in bankruptcy. Stock investors are at the bottom of that repayment list and usually lose all their money ahead of other investors.

However, in this instance, regulators chose to trigger the conversion of the AT1 bonds to equity capital to help the bank, while still offering Credit Suisse shareholders one UBS share for every 22.48 Credit Suisse shares held.

As further explained:

The eleventh-hour Swiss rescue is backed by a massive government guarantee, helping prevent what would have been one of the largest banking collapses since the fall of Lehman Brothers in 2008.

However, the Swiss regulator decided Credit Suisse’s additional tier-1 (AT1) bonds with a notional value of $17 billion will be valued at zero, angering some holders of the debt who thought they would be better protected than shareholders.

AT1 bonds – a $275 billion sector also known as “contingent convertibles” or “CoCo” bonds – can be converted into equity or written off if a bank’s capital level falls below a certain threshold. The deal will also make UBS Switzerland’s only global bank and the Swiss economy more dependent on a single lender.

“Massive guarantee”? Yes:

The deal includes 100 billion Swiss francs ($108 billion) in liquidity assistance for UBS and Credit Suisse from the Swiss central bank.

To enable UBS to take over Credit Suisse, the federal government is providing a loss guarantee of a maximum of 9 billion Swiss francs for a clearly defined part of the portfolio, the government said.

This will be activated if losses are actually incurred on this portfolio. In that eventuality, UBS would assume the first 5 billion francs, the federal government the next 9 billion francs, and UBS would assume any further losses, the government said.

And UBS boasted:

UBS benefits from CHF 25 billion of downside protection from the transaction to support marks, purchase price adjustments and restructuring costs, and additional 50% downside protection on non-core assets.

This caused an immediate drop in the price of other AT1s:

The write-down to zero at Credit Suisse will produce the largest loss in the $275 billion AT1 market to date, dwarfing the 1.35 billion euros ($1.44 billion) bondholders of Spain’s Banco Popular lost in 2017.

Bid prices on AT1 bonds from banks, including Deutsche Bank , HSBC, UBS and BNP Paribas, were among those under pressure on Monday. They recovered marginally but were still down 6-11 points on the day, sending yields sharply higher, data from Tradeweb showed.

A UBS AT1 bond callable in January 2024 was trading at a yield of 27%, up from 12% on Friday, demonstrating how much more costly this type of debt could become in the wake of the Credit Suisse rescue.
…
Funds that track AT1 debt also fell sharply.

Invesco’s AT1 Capital Bond exchange-traded fund was last down 6%, having been over 10% lower earlier. WisdomTree’s AT1 CoCo bond ETF was indicated 9% lower.

At Credit Suisse, the bank’s AT1 bonds were bid as low as 1 cent on the dollar on Monday as investors braced for the wipeout.

But the lawyers will get rich, as usual:

Lawyers from Switzerland, the United States and UK are talking to a number of Credit Suisse Additional Tier 1 (AT1) bond holders about possible legal action after the state-backed rescue of Credit Suisse by UBS wiped out AT1 bonds, law firm Quinn Emanuel Urquhart & Sullivan said on Monday.

Quinn Emanuel said it was in discussions with Credit Suisse AT1 bondholders representing a “significant percentage” of the total notional value the instruments. Quinn Emanuel did not name the bondholders.

Under the UBS-Credit Suisse merger deal, holders of Credit Suisse AT1 bonds will get nothing, while shareholders, who usually rank below bondholders in terms of who gets paid when a bank or company collapses, will receive $3.23 billion.

In Switzerland, the bonds’ terms state that in a restructuring, the financial watchdog is under no obligation to adhere to the traditional capital structure hierarchy, which is how Credit Suisse AT1 bondholders lost out.

And so … what it are the implications for Canadian NVCC preferred shares? I have to say: not much, based on the following two factors.

First, it looks like Credit Suisse was in even worse shape than everyone thought last Friday. As reported above, “shareholders, who usually rank below bondholders in terms of who gets paid when a bank or company collapses, will receive $3.23 billion.” This is after wiping out 16- or 17-billion in AT1 capital (reporting differs according to source, presumably due to rounding and difference in exchange rate conversion). So, if we take these figures at face value – i.e., there hasn’t been too much jiggery-pokery in the values received – the Credit Suisse common had a market value of about NEGATIVE 14-billion on Friday, a far cry from the 8-billion valuation at the close on Friday, never mind the values of previous years:

This is before considering the value of the ‘massive guarantee’ that the Swiss central bank has given UBS, which are quite substantial. So it would seem that AT1 holders wouldn’t have gotten much of a recovery anyway.

Secondly, ‘when in doubt, look at the prospectus’, as the adage goes. Here’s the prospectus for RY.PR.H, taken from RBC’s preferred share page:

Upon the occurrence of a Trigger Event (as defined below), each outstanding Series BB Preferred Share and each outstanding Series BC Preferred Share will automatically and immediately be converted, on a full and permanent basis, into a number of Common Shares equal to (Multiplier x Share Value) ÷ Conversion Price (rounding down, if necessary, to the nearest whole number of Common Shares) (an “NVCC Automatic Conversion”). For the purposes of the foregoing:

“Conversion Price” means the greater of (i) $5.00, and (ii) the Current Market Price of the Common Shares. The floor price of $5.00 is subject to adjustment in the event of (i) the issuance of Common Shares or securities exchangeable for or convertible into Common Shares to all holders of Common Shares as a stock dividend, (ii) the subdivision, redivision or change of the Common Shares into a greater number of Common Shares, or (iii) the reduction, combination or consolidation of the Common Shares into a lesser number of Common Shares. The adjustment shall be computed to the nearest one-tenth of one cent provided that no adjustment of the Conversion Price shall be required unless such adjustment would require an increase or decrease of at least 1% of the Conversion Price then in effect.

“Current Market Price” of the Common Shares means the volume weighted average trading price of the Common Shares on the TSX, if such shares are then listed on the TSX, for the 10 consecutive trading days ending on the trading day preceding the date of the Trigger Event. If the Common Shares are not then listed on the TSX, for the purpose of the foregoing calculation reference shall be made to the principal securities exchange or market on which the Common Shares are then listed or quoted or, if no such trading prices are available, “Current Market Price” shall be the fair value of the Common Shares as reasonably determined by the board of directors of the Bank.

“Multiplier” means 1.0.

“Share Value” means $25.00 plus declared and unpaid dividends as at the date of the Trigger Event.

So, mainly there’s no ‘writedown to zero’ provision, which is one good thing. And secondly, on a trigger event they’re converted to common at a defined price.

It’s not all rosy! The conversion price for the common is defined as the VWAP for two weeks prior to the Trigger (or $5, it that’s higher, which could very well be the case. I bet nobody saw Credit Suisse being taken out for less than $1/share!), and that could be substantially higher than the price at the end of the period, or the price received in some kind of takeover or recapitalization scenario. As a mitigating factor, the value converted at this conversion price is par, or roughly 50% higher than what RY preferreds are trading at now. But the main thing is that the effects of a trigger are conversion into common, which means that whatever else might be the case, preferred shareholders will get some kind of recovery after a trigger event (as long as the common shareholders get something, which will not necessarily be the case), and not be left out in the cold as the Credit Suisse AT1 holders have been. And, as I have always said, expectations for preferred shareholders (NVCC or otherwise) of an operating company in a bankruptcy scenario are basically zero anyway, so any recovery should be considered a bonus!

Now, make no mistake: I do not like Canada’s implementation of the NVCC rules. I don’t like the ‘low trigger’, which basically guarantees that any loss will take place at a time of maximum confusion (as well as acting entirely to mitigate damage to senior creditors, as opposed to forestalling problems before they get more serious), and I don’t like the arbitrary power granted to OSFI to declare a ‘Trigger Event’, which circumvents the courts and gives civil servants one heckofa lot of power. But, it appears to me, a Credit Suisse scenario is not something to worry about.

Update, 2023-3-22: DBRS has released an analysis titled Credit Suisse’s AT1 Controversy Unlikely Outside Switzerland (at time of writing, no password or log-in was required):

Credit Suisse´s AT1 Write-Down Based on a Specific Swiss Contractual Clause

It is important to note that FINMA has not framed the sale of Credit Suisse AG to UBS as a resolution action (restructuring under Swiss terminology). This is a key consideration, as under a resolution, FINMA could have written-down the AT1s but only after CS´s shareholders equity had been completely written-off and cancelled (see link). We consider that FINMA avoided initiating a resolution, asthat could have had unknown consequences for the Swiss and global financial markets. In addition, CS was still not fully resolvable as explained by FINMA in their last Resolution Report in 2022 (see link). As a result, opening resolution procedures (even just during the weekend) might have had important implications on an operative level (derivatives, deposits, other critical contracts). Nevertheless, in order to close the deal, it seems that UBS required downside protection. The deal was closed after granting this protection by writing-off CHF 15.8 billion of AT1s and adding government protection of CHF 9 billion (which applies only after UBS has absorbed the first CHF 5 billion of losses).

We understand that FINMA’s interpretation was that the AT1 write-down was legally possible under a contractual clause called “viability event”. In particular, according to the AT1 prospectus, an irrevocable commitment of extraordinary support from the public sector would trigger this “viability event” thus allowing the total write-down of AT1s. FINMA interpreted the CHF 9 billion protection as extraordinary support from the public sector. However, some investors are arguing that the public sector support was not given to CS but to UBS. As a result, we anticipate CS AT1 bondholders could initiate legal action against these decisions. Furthermore, we observe that the possibility
to writedown and cancel AT1 bondholder rights based on this specific contractual clause is a feature particular to the Swiss banks’ AT1s. Swiss banks issued some of the first AT1s after the previous financial crisis and they were intended to strengthen a bank, both as going concern as well as a gone concern situation.

Implications for Other Resolution Jurisdictions
We view the sale of CS to UBS as positive for financial stability, reducing potential negative market reaction and contagion from a disorderly resolution or bankruptcy of CS. However, it raises some questions as to how authorities will apply their powers. We note some important takeaways from this case, that are applicable to all regimes, including the EU, UK and Canada. First, the complexity of resolution and quasi resolution situations makes the reality different from theoretical resolution planning. Second, the interpretation of the law made by national authorities could be different from what markets expect in these situations. Third, that bail-in strategies for Globally Systemically Important Banks (G-SIB) are difficult and the too big to fail issue is still present.

Nevertheless, we also consider that there are some differences between Switzerland and other regions. Specifically, we view that the decision to impose larger losses on the AT1 securities than on shareholders will not set a precedent in the EU, UK or Canada. We consider that the instruments in these regimes have different wording and authorities have been vocal to clarify that AT1 securities are always senior to equity.

Update, 2023-3-23: DBRS has released a commentary on LRCNs that is very similar in tone to their piece on preferred shares.

Regulation

T+1 Settlement is Coming!

The SEC has announced:

The Securities and Exchange Commission today adopted rule changes to shorten the standard settlement cycle for most broker-dealer transactions in securities from two business days after the trade date (T+2) to one (T+1). The final rule is designed to benefit investors and reduce the credit, market, and liquidity risks in securities transactions faced by market participants.

“I support this rulemaking because it will reduce latency, lower risk, and promote efficiency as well as greater liquidity in the markets,” said SEC Chair Gary Gensler. “Today’s adoption addresses one of the four areas the staff recommended the Commission address in response to the meme stock events of 2021. Taken together, these amendments will make our market plumbing more resilient, timely, orderly, and efficient.”

In addition to shortening the standard settlement cycle, the final rules will improve the processing of institutional trades. Specifically, the final rules will require a broker-dealer to either enter into written agreements or establish, maintain, and enforce written policies and procedures reasonably designed to ensure the completion of allocations, confirmations, and affirmations as soon as technologically practicable and no later than the end of trade date. The final rules also require registered investment advisers to make and keep records of the allocations, confirmations, and affirmations for certain securities transactions.

Further, the final rules add a new requirement to facilitate straight-through processing, which applies to certain types of clearing agencies that provide central matching services. The final rules will require central matching service providers to establish, implement, maintain, and enforce new policies and procedures reasonably designed to facilitate straight-through processing and require them to submit an annual report to the Commission that describes and quantifies progress with respect to straight-through processing.

The adopting release is published on SEC.gov and will be published in the Federal Register. The final rules will become effective 60 days after publication in the Federal Register. The compliance date for the final rules is May 28, 2024.

This is wonderful news, albeit of more interest to institutional investors and their fund managers than to retail. Back in my Canada bond trading days, it was unusual, but not unknown, for clients of the firm to have trades totalling 100-million per side (buy and sell) with a single dealer. Say the market has moved by a buck after trade time but before settlement. Then one side has a loss of 1-million odd, and the other side has a gain of about the same amount. Now say the dealer goes bust before the trade gets settled. The losing side of the trade would settle, but the winning side … maybe. When Confederation Life went bust in the nineties, if you had an outstanding FX trade that you were losing money on, it settled. If you were winning … get in line, buddy! So this is a risk that is reduced by faster settlement.

There are implications for retail, though … everybody remembers the Robin Hood / Meme Stock problem, when Robin Hood suddenly started getting very fussy about what orders they would accept … and although you’ll find lots of vitriol on the web directed at them by newbie retails, you’ll also learn that few of these guys understood the problem: the problem was that clearing corporations demand collateral to mitigate the settlement risk described above:

New York markets had just fired up, and the investing world was tuning in for Thursday’s episode of the continuing drama: Legions of Robinhood Markets investors versus hedge-fund Goliaths.

But within minutes, a shock wave invisible to the outside world rattled the mechanics of Wall Street — sending Robinhood rushing for more than $1 billion of additional cash. The stock market’s central clearing hub had demanded large sums of collateral from brokerages including Robinhood that for weeks had facilitated spectacular jumps in shares such as GameStop Corp.

The Silicon Valley venture with the wildly popular no-fee trading app came to a crossroads. It reined in the risk to itself by banning certain trades and unwinding client bets — igniting an outcry from customers and even U.S. political leaders. By that night, word was emerging that Robinhood had raised more than $1 billion from existing investors and drawn hundreds of millions more from bank credit lines to weather the storm.
…
The question is whether such critics will dig into the industry’s inner workings, where pressure mounted on Robinhood and other firms to limit certain trades. That would put a rare spotlight on arcane parts of the market designed to prevent catastrophe, such as the Depository Trust & Clearing Corp.

One key consideration for brokers, particularly around high-flying and volatile stocks like GameStop, is in the money they must put up with the DTCC while waiting a few days for stock transactions to settle. Those outlays, which behave like margin in a brokerage account, can create a cash crunch on volatile days, say when GameStop falls from $483 to $112 like it did at one point during Thursday’s session.
…
The trouble on Thursday began around 10 a.m., when after days of turbulence, the DTCC demanded significantly more collateral from member brokers, according to two people familiar with the matter.

A spokesman for the DTCC wouldn’t specify how much it required from specific firms but said that by the end of the day industrywide collateral requirements jumped to $33.5 billion, up from $26 billion.

Brokerage executives rushed to figure out how to come up with the funds. Robinhood’s reaction drew the most public attention, but the firm wasn’t alone in limiting trading of stocks such as GameStop and AMC Entertainment Holdings Inc.

In fact, Charles Schwab Corp.’s TD Ameritrade curbed transactions in both of those companies on Wednesday. Interactive Brokers Group Inc. and Morgan Stanley’s E*Trade took similar action Thursday.

So, faster settlement will alleviate, to a large degree, the amount of settlement risk there is in the system and, hopefully, reduce the chance of serious volatility freezing the markets.

There was a lot of self-congratulation. Chair Gary Gensler stated:

First, the amendments will shorten the standard settlement cycle by half, from two business days (“T+2”) to one business day (“T+1”). The amendments also will halve the settlement cycle for trades relating to initial public offerings, from T+4 to T+2. As they say, time is money. Halving these settlement cycles will reduce the amount of margin that counterparties need to place with the clearinghouse. This lowers risk in the system and frees up liquidity elsewhere in the market.

Now, that’s not to say this change will be new; in fact, this change simply brings us back to the T+1 settlement cycle our markets used up until the 1920s. It also aligns with the T+1 cycle used in the $24 trillion Treasury market.
…
Today’s adoption addresses one of the four areas the staff recommended the Commission address in response to the meme stock events of 2021. Further, the implementation for these amendments will be set to after Memorial Day weekend (May 28, 2024). This implementation comes more than three years after key industry members first proposed shortening the settlement cycle, and a year and a quarter from now, providing sufficient time in my view for the transition. Further easing the transition, the implementation date will occur during a three-day holiday weekend.

Commissioner Jaime Lizárraga stated:

Why does this matter to the investing public? Because buyers and sellers of securities will receive their cash and securities a day earlier under T+1 than they do currently. And because market participants can allocate their capital more quickly and efficiently. Based on the public comments to the proposal, these benefits accrue to retail investors in particular.

Reducing the current settlement time in half will alleviate some of the downsides of the current T+2 cycle, such as counterparty, market, liquidity, credit, and other risks. A longer settlement time also requires risk management tools, such as margin requirements, that carry significant costs. Shortening the settlement cycle not only helps reduce these risks and costs but lowers volatility and makes our markets more fair and efficient.

The risks of longer settlement times are not just theoretical. In January 2021, unprecedented price volatility in so-called “meme stocks” challenged many retail investors’ faith in our in financial markets. Clearing agencies in equities and options experienced record volumes cleared. In the face of high volume and volatility, market utilities had to issue significant margin calls. In reaction to these margin calls, certain brokers restricted trading in some, or all, of the meme stocks. According to media reports, at least one broker’s decisions to halt trading came at the peak of the market and infuriated many retail investors. Investors have filed approximately 50 class action lawsuits claiming substantial harm from this broker’s trading halt.

Commissioner Caroline A. Crenshaw stated (with lots of valuable footnotes):

Specifically, a shorter settlement cycle should reduce the number of outstanding unsettled trades, reduce clearing agency margin requirements, and allow investors quicker access to their securities and funds. Longer settlement periods, on the other hand, are associated with increased counterparty default risk, market risk, liquidity risk, credit risk, and overall systemic risk.[7]

Commenters were overwhelmingly in favor of shortening the settlement cycle.[8] We received supportive comments from a broad range of stakeholders, including individual investors, investor advocates, clearing agencies, and broker-dealers.[9] Some commenters raised concerns regarding the proposed changes related to the processing of institutional trades,[10] firm commitment offerings,[11] and security-based swaps,[12] and the final rule reflects certain changes from the proposal in response to those comments. A number of commenters also raised concerns about the implementation timeline, which has been extended by several months from the proposed date to facilitate a smooth transition.[13] The new compliance date would provide market participants more than fifteen months to prepare for the transition.[14]

The proposal also included a request for comment on the possibility of settling trades by the end of the trade date, or what we call “T+0.” Some commenters highlighted challenges relating to multi-lateral netting, securities lending practices, and other issues.[15] However, many others expressed support for an eventual move to T+0.[16] While it is clear that T+0 will entail greater operational and technological challenges than the move to T+1, I agree with commenters that such a move may be both desirable and feasible in the future, and I look forward to working with my colleagues and stakeholders toward that important goal.[17]

Commissioner Mark T. Uyeda was a little bitter (bolding added):

While the net benefits of a shorter settlement cycle are clear, T + 1 can potentially increase some operational risks. There will be less time to address errors within the process and, in some circumstances, less time to deal with trading entities that are suddenly confronting massive and unexpected trading losses within the settlement cycle timeframe. There is also less time for regulators to identify and freeze the potential proceeds from potential frauds, such as, insider trading and market manipulation, before those proceeds exit our jurisdiction. These arguments and considerations, however, do not ultimately weigh against shortening the settlement cycle, but they provide reason for ensuring readiness among market participants. This speaks to the implementation date.

Ensuring a smooth transition will take significant investment and systems changes as well as operational and computational testing among broker-dealers, clearing firms, investment advisers, custodians, payment systems, and so on. Detailed planning is required, as is process adjustment, organizational change, and changes in the relationships among market participants. There is asymmetry in terms of costs and benefits—a smooth transition would provide net benefits for investors and U.S. markets to be accrued over the long-term in the future. On the other hand, the downside of a rough, turbulent transition could be steep, and could induce substantial harm in the short-run. That asymmetry cautions us to provide sufficient time to ensure a smooth transition.

Many comment letters have emphasized the need for more time than the Commission proposed.[5] Many have pointed to the 2024 Labor Day weekend as the implementation date. It would have the added advantage that Canada is also moving forward with T + 1 around the same time. Instead, the Commission appears to be ready to adopt May 28, 2024 as the implementation date.[6] In my view, we are in an imprudent rush away from a sensible transition date and, for that reason, I am unable to support the final rule.

Commissioner Hester M. Peirce also complained about implementation (bolding added):

I support the plan to move to T+1, but do not support the proposed timeline for making this change. Shortening the settlement cycle is a way to remove some risk from our markets. Mandating that the change occur in May 2024, however, could pose risks of its own by forcing the transition before market participants are ready. I propose instead a September 3, 2024 implementation date. Let me explain why:

  • Although preferable to the proposed March 31, 2024 implementation date, the May 28, 2024 date is still too early. Shortening the settlement cycle by one business day is a big change with implications all across the market. We cannot afford a cavalier approach.
  • Many commenters called for a September 3, 2024 date to ensure that the transition would happen with minimal disruption to the markets.
  • Tuesday, September 3, 2024 is the first business day after the 3-day Labor Day weekend, and Canada, the only jurisdiction currently planning on moving with us to T+1, shares this 3-day weekend. The transition from T+3 to T+2 occurred successfully over Labor Day weekend in 2017.
  • This later date would give other foreign market participants the time to work out some of the challenges they will face from our transition to a shorter settlement cycle than they have in their markets.
  • The additional three months will allow more time for firm-specific and coordinated, industry-wide testing, which will make a smoother transition more likely.
  • The transition from T+2 to T+1 is likely to present numerous operational challenges—some of them more difficult than in the last transition—related to, among other things, pre- and post-trade processes, securities lending, foreign exchange transactions, and processing corporate actions.
  • The transition is happening at the same time the market is processing many other regulatory changes.

I do not have any questions for the staff, but do want to make one final plea to Chair Gensler. Why not adopt a September 3, 2024 compliance date? I will vote for the rule if you make this change.

Contingent Capital

OSFI Revises Rules for LRCNs; Finally Provides Information for Insurers

The Office of the Superintendant of Financial Institutions Canada (OSFI) has announced:

OSFI has published an update to its July 18, 2020 capital ruling on the Limited Recourse Capital Notes (LRCNs). The revised ruling now addresses LRCN issuances from institutions of all sizes and across different industry sectors.

The revisions include a number of clarifications to the ruling’s conditions and limitations, which are part of OSFI’s prudent approach to assessing the quality and quantity of financial instruments used as regulatory capital. This is consistent with our mandate to protect the rights and interests of depositors, policyholders and financial institution creditors, while also allowing financial institutions to compete effectively and take reasonable risks.

The ruling continues to conclude that federally regulated financial institutions may recognize the LRCNs as regulatory capital subject to the capital treatment, conditions and limitations set out in the revised ruling. Should you have any questions, please contact CapitalConfirmations@osfi-bsif.gc.ca.

The new limits are set out in the appendix to the new rules:

LRCN Issuance Limitations by FRFI Sector
Note: For life insurers, the following limitations supplement and are subject to any existing capital composition limits set out in OSFI’s capital guidelines. P&C insurers and mortgage insurers should consult OSFI’s Capital Division in respect of the limitations applicable to any prospective LRCN issuances.

FRFI
Sector		 Regulatory
Capital
Treatment		 LRCN Issuance Cap Floor
Deposit-
Taking
Institutions		 AT1 Greater of $150 million, 0.75%
RWA, or 50% of the
institution’s aggregate net AT1
capital		 Lesser of 0.30% RWA or 20% of
the institution’s aggregate AT1
capital
Life Tier 1 Capital
other than
Common
Shares		 Greater of $150 million or
12.5% of Net Tier 1 capital		 5.0% of Net Tier 1 capital

The “Floor” has the following effect:

The Cap may be removed with the prior approval of OSFI’s Capital Division. In seeking this approval, a FRFI must demonstrate that it has issued institutional preferred shares and/or other Additional Tier 1 capital instruments (other than LRCNs) targeted towards institutional investors that, in aggregate, are no less than the applicable limit, or Floor, set out in the Appendix. If the FRFI’s outstanding institutional preferred shares and/or other Additional Tier 1 capital instruments issued to institutional investors were to subsequently drop below the Floor, the FRFI would not be permitted to issue additional LRCNs in excess of the Cap until it has re-established compliance with the Floor. The Floor will not apply where the LRCNs are issued exclusively to a FRFI’s affiliates.

Regulation

IAIS Says No To DeemedRetractions

The International Association of Insurance Supervisors has released a bevy of documents related to the supervision of Internationally Active Insurance Groups.

Of these, the most important for our purposes is the “Technical Note on ICS Version 2.0 for the monitoring period” which states:

Principal Loss Absorbency Mechanism (PLAM): A distinction is made for mutual and non-mutual IAIGs. For non-mutual IAIGs, the 10% limit for Tier 1 Limited financial instruments will be maintained for Tier 1 Limited financial instruments that do not have a PLAM. An additional 5% allowance is granted to those Tier 1 Limited financial instruments that do have a PLAM. The limits are stated as a % of the ICS capital requirement.

For mutual IAIGs: A PLAM is not required as part of Tier 1 Limited capital resources and the limit for Tier 1 Limited capital resources is maintained at 30% of the ICS capital requirement

So that’s an end to the saga that began in February, 2011. As an investor, I’m shocked; as a taxpayer who will end up footing the bill if one of our outsized insurance companies goes down, I’m disappointed.

Update: An end? Or a new beginning? The Canadian Office of the Superintendent of Financial Institutions – which has disgraced itself throughout the negotiations for ICS 2.0 – has announced:

While broadly supportive of the goals of the Insurance Capital Standard (ICS), the Office of the Superintendent of Financial Institutions (OSFI) did not support the ICS design proposed for a five-year monitoring period at the Executive Committee Meeting of the International Association of Insurance Supervisors (IAIS) in Abu Dhabi, United Arab Emirates.

OSFI’s view is that that the Standard in its current form is not fit for purpose for the Canadian market. Specifically, the proposed capital requirements for long-term products are too high to be compatible with OSFI’s mandate of allowing Canadian insurers to compete and take reasonable risks.

During the five-year monitoring period, OSFI will continue its work in trying to achieve an international capital standard for insurance companies that works for all jurisdictions.

Quick Facts

  • Canadian insurers will continue to be subject to the requirements of OSFI’s robust capital frameworks for federally regulated insurance companies.
  • An initiative of the IAIS, the International Capital Standard is a proposed common capital standard for large internationally active insurance groups.

So, maybe a PLAM for Tier 1 Limited capital resources is a bargaining chip …

Update: There hasn’t been much press coverage of this, but here are two articles:

Update, 2019-11-17: States and Feds Split on Major World Insurance Standards Deal

Update, 2019-11-18: OSFI rebuffs global capital rules for insurers.

Issue Comments

FixedReset Prospectuses Are Imprecise!

As we all know, FixedResets will reset their dividend every five years based on the Government of Canada Five Year yield (“GOC-5 rate” or “GOC-5 yield”) and therefore the prospectus for each issue needs to include information regarding exactly how that yield is determined.

The prospectus for ALA.PR.G (chosen because I can link to it!) contains typical language with respect to this process:

“Bloomberg Screen GCAN5YR Page” means the display designated as page “GCAN5YR” on the Bloomberg Financial L.P. service (or such other page as may replace the GCAN5YR page on that service) for purposes of displaying Government of Canada bond yields.

“Government of Canada Yield” on any date means the yield to maturity on such date (assuming semi-annual compounding) of a Canadian dollar denominated non-callable Government of Canada bond with a term to maturity of five years as quoted as of 10:00 a.m. (Toronto time) on such date and that appears on he Bloomberg Screen GCAN5YR Page on such date; provided that if such rate does not appear on the Bloomberg Screen GCAN5YR Page on such date, then the Government of Canada Yield shall mean the arithmetic average of the yields quoted to AltaGas by two registered Canadian investment dealers selected by AltaGas as being the annual yield to maturity on such date, compounded semi-annually, that a non-callable Government of Canada bond would carry if issued, in Canadian dollars, at 100% of its principal amount on such date with a term to maturity of five years.

I am not aware of any material differences in the definitions between prospectuses.

So this sounds pretty good, right? The GOC-5 yield will be calculated by an independent third party with no ambiguity and complete verifiability, right? Wrong.

As noted in the post Reset Calculation Oddity for 2019-9-30 / 2019-10-1, the following four issues had the GOC-5 rate underlying their dividends recalculated by their issuers on September 3:

Basis Comparison of Resets
Ticker Issue Reset Spread Announced Rate Implied GOC-5 Yield Screenshot
ALA.PR.G 306bp 4.242% 1.182% LINK
EFN.PR.E 472bp 5.903% 1.183% LINK
BAM.PF.F 286bp 4.029% 1.169% LINK
DC.PR.B 410bp 5.284% 1.184% LINK

The AltaGas screenshot shows they made a slight mistake: the time of the screenshot is 10:00:18, so they missed their proper time by 18 seconds, although they could argue that the prospectus only uses four significant figures and therefore their calculation is completely OK. However, each of the other screenshots shows a genuine effort being made to determine just what exactly the GOC-5 rate was at 10:00:00.00000 and each methodology resulted in a different answer.

Four companies, four identically specified calculations, four different answers.

I will be the first to agree that the variance is minor: the spread between the highest and lowest measurement is only 1.5bp and that’s not a lot. On a typical issue size of $250-million, that comes to $37,500 annually or $187,500 over the full five years. On a per-share basis, a 1.5bp yield difference comes to $0.00375 p.a., slightly less than two cents over the full five years.

But that’s not the point. First, the prospectus should specify the yield to be used in a completely precise manner. To quote again from the representative language of the ALA.PR.G prospectus:

“Annual Fixed Dividend Rate” means, for any Subsequent Fixed Rate Period, the annual rate of interest (expressed as a percentage rounded to the nearest one hundred thousandth of one percent (with 0.000005% being rounded up)) equal to the sum of the Government of Canada Yield on the applicable Fixed Rate Calculation Date and 3.06%.

What’s the point of being so horrifyingly precise about the rounding of the Annual Fixed Dividend Rate when the underlying figure is nowhere near that precisely measured?

In addition, once this becomes widely known, what’s to prevent a company from determining the GOC-5 yield in as many ways as their Bloomberg users can invent and choosing the lowest answer?

Clearly, the Bloomberg methodology is not adequate for the task of determining a precise, public, third-party figure and the procedure needs to be changed. The first alternative that leaps to mind is the Bank of Canada’s bond yield reporting:

Selected benchmark bond yields are based on mid-market closing yields of selected Government of Canada bond issues that mature approximately in the indicated terms. The bond issues used are not necessarily the ones with the remaining time to maturity that is the closest to the indicated term and may differ from other sources. The selected 2-, 5-, 10-, or 30-year issues are generally changed when a building benchmark bond is adopted by financial markets as a benchmark, typically after the last auction for that bond.

Yes, it’s not quite the same thing and yes, there might be a perceived problem if the benchmark changes near the time of calculation (typically, new benchmarks will trade to yield less than the ‘off the run’ issues they supersede). I don’t care. I want something precise, public (certainly more public than a subscription to a Bloomberg terminal!) and prepared by an independent third party. If somebody has a better idea, let’s hear it.

Regulation

IAIS SecGen Discusses ICS 2.0 Timeline

The International Association of Insurance Supervisors released its May, 2019, Newsletter today, which was led by a piece from the Secretary-General, Jonathan Dixon:

Our committee meetings next month in Buenos Aires mark an important point in the IAIS’ journey to a global Insurance Capital Standard (ICS). The IAIS embarked on the development of the ICS to create a common language
for supervisory discussions of group solvency of internationally active insurance groups. In June, the focus of our committee discussions will shift from design to implementation issues.

The final round of field testing is now underway, with data due at the end of July. While some ICS design elements remain to be finalised this year, the IAIS remains committed to resolving those elements and beginning the monitoring period in 2020, while recognising that the ICS will continue to evolve during this period. This includes possible refinements and corrections of major flaws or unintended consequences identified during the monitoring period.

In June, we will discuss the overall framework for the monitoring period, including confidentiality safeguards around disclosure of the ICS results and modalities for considering unintended consequences, given that our intention has always been to undertake this work once the ICS is sufficiently developed. We will also further our discussions on the timelines, process and governance for developing comparability criteria and completing the comparability assessment of other solvency regimes relative to the ICS.

As we move towards November and the adoption of ICS Version 2.0 for the monitoring period, we will continue our constructive engagement with stakeholders in order to ensure that there is greater clarity on the process for finalising and implementing the ICS.

This is all consistent with previous schedules provided for ICS 2.0, which include the IAIS deliberations regarding the definition of Insurance company Tier 1 Limited Capital (which includes preferred shares); I take the view that rules comparable, if not identical to the bank NVCC rules will be imposed by OSFI at some point in the future.

Contingent Capital

S&P Revises Bank Outlook to Stable on Federal Complacency

Standard & Poor’s has announced:

  • •We continue to evaluate the likelihood, degree, and timeframe with respect to which the default risk of systemically important Canadian banks may change as a result of the government’s progress toward introducing a bank bail-in framework.
  • •We now expect that the timeframe could be substantially longer than we had previously assumed. We see the absence of the topic from the new government’s Dec. 4 Speech from the Throne as recent, incremental evidence in this regard.
  • •We now do not expect to consider the removal of rating uplift for our expectation of the likelihood of extraordinary government support from the issuer credit ratings (ICRs) on systemically important Canadian banks until a point beyond our standard two-year outlook horizon for investment-grade ratings, if at all.
  • •When and if we remove such uplift, the potential ratings impact will also consider uplift for additional loss-absorbing capacity, as well as any changes to our stand-alone credit profiles on these banks.
  • •As a result, we are revising our outlooks on all systemically important Canadian banks to stable from negative.

RATING ACTION
On Dec. 11, 2015, Standard & Poor’s Ratings Services revised its outlooks on the Canadian banks that it views as having either “high” (Bank of Montreal, The Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, The Toronto-Dominion Bank), or “moderate” (Caisse centrale Desjardins and National Bank of Canada) systemic importance, to stable from negative (see ratings list). The issuer credit ratings (ICRs) on the banks are unchanged.

RATIONALE
We believe that the potential negative ratings impact of a declining likelihood of extraordinary government support, at least within our standard two-year outlook horizon, has subsided. This reflects our updated view that there could be an extended implementation timetable–2018 or later–for the proposed Canadian bail-in framework. Importantly, at the point we would consider removing any uplift from the likelihood of extraordinary government support from our ratings, we would also consider the potential ratings impact of any uplift for additional loss-absorbing capacity (ALAC), as well as any
changes to our stand-alone credit profiles (SACPs) on these banks. In our view, the extended timetable introduces some potential that either the presence of ALAC or fundamental changes in credit quality at individual banks might come into play more than under the previously contemplated timetable.

We had revised our outlooks on systemically important Canadian banks to negative chiefly in reaction to the former government’s “Taxpayer Protection and Bank Recapitalization Regime” consultation paper of Aug. 1, 2014, as we then expected a bail-in regime could be fully implemented by 2016 (see “Outlook On Six Big Canadian Banks Revised To Negative Following Review Of Bail-In Policy Proposal,” published Aug. 8, 2014, on RatingsDirect). A number of subsequent developments have caused us to re-evaluate this expectation:

  • •In its April 2015 budget proposal, the former government affirmed its intention to introduce a bank bail-in regime in Canada, but it provided only very limited additional information relative to what it had outlined in its 2014 consultation paper; nor did the government make substantial subsequent public statement on the topic; nor did it specify timing for the announcement of its fully-developed (post-consultation) legislative proposal.
  • •The Oct. 19 federal election changed the party in government to Liberal (center-left), from Conservative (center-right). The former government’s proposed bail-in regime did not feature prominently in election debates.
  • •The new government’s Dec. 4 Speech from the Throne made no mention of the proposed bail-in framework, nor were any of the legislative priorities enumerated therein closely related, in our opinion. We believe this indicates the introduction of a bail-in framework is not among the immediate priorities of the new government.

Moreover, with Canada experiencing no government bank bail-outs, nor large bank failures, for decades, we believe the political incentive to rapidly end “too-big-to-fail” is less in Canada than in the U.S. and several EU countries, which are jurisdictions under which we have already removed uplift for our expectation of the likelihood of extraordinary government support from our ratings (see “U.S. Global Systemically Important Bank Holding Companies Downgraded Based On Uncertain Likelihood Of Government Support,” and “Most European Bank Ratings Affirmed Following Government Support And ALAC Review,” both published Dec. 2, on RatingsDirect). We will take this factor into consideration as we continue to evaluate our view on the likelihood of extraordinary government support in Canada relative to not only the U.S. and Europe, but also other jurisdictions where we maintain a government support assessment of “supportive” or “highly supportive” under our criteria (such as for many countries in Latin America and Asia-Pacific; see “Banking Industry Country Risk Assessment Update: November 2015,” published Nov. 27).

We now believe the procedural hurdles to passing legislation and related regulations (the latter after passage of the former) for a bail-in regime will alone require a minimum of one-to-two years, after the new government decides on a final legislative framework to propose to Parliament. Considering all of this, we now expect the eventual date for initial implementation of the bail-in regime (that is, banks issuing bail-inable debt) could be in 2018 or later.

In addition, and in contrast to bail-in frameworks outlined by U.S. authorities or in European countries like Germany, Canadian officials’ statements have made clear that only debt issued or renegotiated after an initial implementation date would be subject to conversion. It will take some time for the banks to issue or renegotiate bail-inable debt. We believe this means it could take several years after the initial implementation date before we would consider a Canadian bail-in regime effective, so as to provide a viable alternative to the direct provision of extraordinary government support.

As well, and again in contrast to the U.S. and EU jurisdictions, Canadian governments have made no attempt to limit their ability to provide direct extraordinary support to their banks, if needed. We expect bailing in senior creditors to be the first Canadian policy response in the face of a crisis. At the same time, we believe Canadian governments would be likely to consider all policy options, in such a circumstance. It is therefore not certain that the introduction of a bail-in regime would of itself result in our revising our government support assessment on Canada to “uncertain” from the current “supportive” and the removal of rating uplift for our view on the likelihood of extraordinary government support from our ICRs on systemically important Canadian banks. Rather, our decision would depend, among other factors, on the details of the eventual bail-in regime, including the extent to which bail-inable and unbail-inable senior debt is distinguishable.

Partly to honor G-20 and other international commitments, the Canadian government will, we expect, present a finalized legislative proposal for the bail-in framework in 2016 or 2017. However, we expect an implementation date that could be in 2018 or later, and we think it could take at least one and possibly several years more for substantial bail-in eligible debt to be in place. With a runway that long, the potential ratings impact from removing uplift for the likelihood of extraordinary government support is beyond our standard two-year outlook horizon for investment-grade ratings, and could by then be more meaningfully affected by either ALAC uplift (from the bail-inable debt, assuming our related criteria are met) or SACP changes, than under the previously contemplated timetable.

When the government presents the detailed provisions of the framework, along with a more specific timeframe, we will review the applicable notching for various bank liabilities, taking into account the framework’s implications on different instruments. We expect that issue ratings on new bail-inable instruments will be at a level that is notched in reference to banks’ SACPs, while ratings on non-bailinable senior debt may continue to incorporate rating uplift above the banks’ SACPs, based on our expectation of the likelihood of extraordinary government support, or ALAC.

OUTLOOK
Our outlooks on the systemically important Canadian banks are stable, based on our reassessment of the likelihood, degree, and timeframe with respect to which the default risk of systemically important Canadian banks may change as a result of the government’s progress toward introducing a bank bail-in framework. We believe that the likelihood of extraordinary government support will continue to be a factor in systemically important Canadian bank ratings throughout the current outlook period.

Moreover, we believe these banks will continue to exhibit broad revenue diversification, conservative underwriting standards, and strong overall asset quality. Our current view is that the impact of low oil prices on their profitability and credit quality will be contained, given the modest direct exposure of the banks to the oil and gas sector, and the limited knock-on impact so far on consumer credit in regional economies affected by low oil prices.

On the other hand, we continue to monitor a number of key downside risks to our ratings on these banks, including low margins, high Canadian consumer leverage, residential real estate prices we believe are at least somewhat inflated in some parts of Canada, a Canadian macroeconomic outlook that is very tentative, and the higher-risk nature of certain recent foreign acquisitions.

The August 2014 imposition of Outlook-Negative was reported on PrefBlog, as was the federal consultation on the recapitalization regime. As far as I can tell, the comments received on the consultation paper have not been published; I believe this is because Canadians are too stupid to understand smart stuff like legislation and parliament and all that – if given a pile of comments to work through, we’d probably try to eat them.

Issues affected are:

BMO.PR.K, BMO.PR.L, BMO.PR.M, BMO.PR.Q, BMO.PR.R, BMO.PR.S, BMO.PR.T, BMO.PR.W, BMO.PR.Y and BMO.PR.Z

BNS.PR.A, BNS.PR.B, BNS.PR.C, BNS.PR.D, BNS.PR.L, BNS.PR.M, BNS.PR.N, BNS.PR.O, BNS.PR.P, BNS.PR.Q, BNS.PR.R, BNS.PR.Y and BNS.PR.Z

CM.PR.O, CM.PR.P and CM.PR.Q

NA.PR.Q, NA.PR.S and NA.PR.W

RY.PR.A, RY.PR.B, RY.PR.C, RY.PR.D, RY.PR.E, RY.PR.F, RY.PR.G, RY.PR.H, RY.PR.I, RY.PR.J, RY.PR.K, RY.PR.L, RY.PR.M, RY.PR.N, RY.PR.O, RY.PR.P RY.PR.W and RY.PR.Z

TD.PF.A, TD.PF.B, TD.PF.C, TD.PF.D, TD.PF.E, TD.PF.F, TD.PR.S, TD.PR.T, TD.PR.Y and TD.PR.Z

Contingent Capital

Update On OSFI Insurer Regulation

OSFI Assistant Superintendent Neville Henderson gave a speech to the 2015 Life Insurance Invitational Forum:

Domestic Insurance Capital Standards

On the domestic front, we are still on track to implement OSFI’s new life insurance regulatory capital framework in 2018. The new capital framework will provide a superior risk based assessment methodology for determining capital requirements. The new test will make use of more current analysis and methodologies as well as explicitly taking into account mitigating actions and diversification benefits. It will allow our capital requirements to remain state of the art compared to those of other jurisdictions.

The capital changes in the new framework are explicitly calibrated to a consistent level of conditional tail expectation (CTE) across the various risks. Actuarial valuation of insurance company liabilities are explicitly intended to include conservative margins with the degree of conservatism varying across risks.

To help ensure that this approach results in consistent capital measures across companies, OSFI has asked the Canadian Institute of Actuaries and the Actuarial Standards Board to consider certain issues with a view to updating actuarial standards and /or guidelines if required.

To avoid double counting and inconsistent treatment of different risks, this new framework will include margins for adverse deviations as an available capital resource.

While we are awaiting the results of Quantitative Impact Study (QIS)7, we are in the process of planning to conduct two framework runs, one in 2016 followed by another one in 2017. These “test drives” will allow us to validate the new capital test and help insurers gear up for the updated regulatory compliance requirements under the new framework.

We should also have a final guideline ready for issue in July 2016, following input from the industry on the draft. Any anomalies uncovered in the testing will be taken into consideration prior to implementation. This will allow time for industry feedback and enable insurers to plan and prepare their systems for implementation of the framework in early 2018.

Global Insurance Capital Developments

While work continues on the domestic front, there are also developments in standards for internationally active insurers.

The International Association of Insurance Supervisors (IAIS) is refining the Basic Capital Requirement (BCR) and Higher Loss Absorbency (HLA) requirements for Global Systemically Important Insurers (GSIIs) for implementation in 2019. Work in this area is aimed at mitigating or avoiding risks to the global financial system.

To eventually replace the BCR, the IAIS is developing an internationally agreed upon risk based capital test. The Insurance capital standard (ICS 1.0) for the broader list of Internationally Active Insurance Groups (IAIG) will be ready by the end of 2016, for implementation in 2019.

OSFI looks carefully at the Canadian marketplace and Canadian requirements before deciding whether to adopt international standards. We will take ICS into consideration as we fine tune our current capital tests. The work we do on the OSFI life insurance framework already includes many of the changes stemming from these international standards and we don’t expect ICS 1.0 to be as sophisticated as our current Minimum Continuing Capital and Surplus Requirements (MCCSR) capital test. Consequently, we do not foresee a need to implement any significant changes.

The significant changes will likely come as ICS 2.0 is finalized. It may bring sufficient worldwide convergence for OSFI to start thinking about implementation.

The important thing about ICS is that this is what will determine whether or not preferred shares must be convertible into equity (or have other pre-bankruptcy capital loss absorption features) in order to be counted as Tier 1 capital. This proposal is outlined in the Consultation Paper “Risk-based Global Insurance Capital Standard” which is available in a ludicrously inconvenient manner, paragraph 92 with associated question 25:

92. The IAIS is considering a requirement for a principal loss absorbency mechanism to apply to Tier 1 instruments for which there is a limit. This principal loss absorbency mechanism would provide a means for such instruments to absorb losses on a going-concern basis through reductions in the principal amount in addition to cancellation of distributions.

Question 25. Should Tier 1 instruments for which there is a limit be required to include a principal loss absorbency mechanism that absorbs losses on a going-concern basis by means of the principal amount in addition to actions with respect to distributions (e.g. coupon cancellation)? If so, how would such a mechanism operate in practice and at what point should such a mechanism be triggered?

OSFI’s response to this question is available in the document “Compiled Responses to ICS Consultation 17 Dec 2014 – 16 Feb 2015”, which is also available in a ludicrously inconvenient manner:

No, OSFI does not support the inclusion of a principal loss absorbency mechanism on Tier 1 instruments for which there is a limit. Tier 1 instruments must be able to absorb losses on a going concern basis, which these instruments do through coupon cancellation.

Despite this, I expect that OSFI will adopt whatever ends up being in ICS, as in this way any future criticism will be deflected to the international body and they will be able to keep their jobs and continue angling for future employment with those whom they currently regulate.

OSFI’s response to this – and other – questions has never been explained to the Canadian public as far as I know, because we’re disgusting taxpayer and investor scum, not worth the dirt underneath our own fingernails.

Further discussion of the capital standard and my reasons for believing that the NVCC rule will be applied to insurers and insurance holding companies are provided in every edition of PrefLetter.