Category: Regulatory Capital

In Preferreds & Tier 1 Capital (Part 1) we had a quick look at some balance sheets and at the OSFI specifications for preferred shares’ qualifications for Tier 1.

I was interested enough in the banks’ capital structures to extend the table:

So there’s a wide variation in reliance upon preferred shares, to say the least! To continue this investigation, we should look at the ranking of preferred shares relative to Innovative Tier 1 Capital … are they junior, senior, or parri passu?

For the sake of an example, I looked at the prospectus for the RY.PR.E new issue:

Rights on Liquidation

In the event of our liquidation, dissolution or winding-up, the holders of the Series AE Preferred Shares will be entitled to receive $25.00 per share, together with all dividends declared and unpaid to the date of payment, before any amount may be paid or any or our assets distributed to the registered holders of any shares ranking junior to the Series AE Preferred Shares. The holders of the Series AE Preferred Shares will not be entitled to share in any further distribution of our assets.

Restrictions on Dividends and Retirement of Shares

So long as any of the Series AE Preferred Shares are outstanding, we will not, without the approval of the holders of the Series AE Preferred Shares:

• pay any dividends on any second preferred shares, any common shares or any other shares ranking junior to the Series AE Preferred Shares (other than stock dividends in any shares ranking junior to the Series AE Preferred Shares); or
• redeem, purchase or otherwise retire any second preferred shares, any common shares or any other shares ranking junior to the Series AE Preferred Shares (except out of the net cash proceeds of a substantially concurrent issue of shares ranking junior to the Series AE Preferred Shares); or
• redeem, purchase or otherwise retire less than all the Series AE Preferred Shares; or
• except pursuant to any purchase obligation, sinking fund, retraction privilege or mandatory redemption provision attaching to any series of preferred shares, redeem, purchase, or otherwise retire any other shares ranking on a parity with the Series AE Preferred Shares;

unless all dividends up to and including the dividend payment date for the last completed period for which dividends are payable have been declared and paid, or set apart for payment, in respect of each series of cumulative first preferred shares then issued and outstanding and all other cumulative shares ranking on a parity with the first preferred shares and we have paid, or set apart for payment, all declared dividends in respect of each series of non-cumulative first preferred shares (including the Series AE Preferred Shares) then issued and outstanding, and on all other non-cumulative shares ranking on a parity with the first preferred shares. See “Bank Act Restrictions” in the prospectus.

Now lets look at a recent issue of Innovative Tier 1 Capital : RBC TruCS – Series 2015. These are sold as, and trade as, bonds with a maturity in 2015, with a spread to regular bonds due to the fact that non-repayment in 2015 is an unpleasant event for the bank, but is not actually a default:

On each Regular Distribution Date following December 31, 2015, the Indicated Distribution per RBC TruCS — Series 2015 will be determined by multiplying $1,000 by one half of the sum of the Bankers’ Acceptance Rate (as herein defined) for the Distribution Period (as herein defined) immediately preceding such Distribution Date plus 150 basis points.
…
Pursuant to the terms of a Bank Share Exchange Trust Agreement between the Bank, the Exchange Trustee (as defined herein) and the Trust (the ‘‘Bank Share Exchange Agreement’’), the Bank has covenanted for the benefit of holders of RBC TruCS — Series 2015 (the ‘‘Dividend Stopper Undertakings’’) that if, on any Regular Distribution Date, the Trust fails to pay the Indicated Distribution in full on the RBC TruCS — Series 2015, the Bank will not declare dividends of any kind on any preferred shares or common shares of the Bank (the ‘‘Bank Common Shares’’ and collectively with preferred shares, the ‘‘Dividend Restricted Shares’’) until the month commencing immediately after the third Dividend Declaration Month (as defined herein) following the Trust’s failure to pay the Indicated Distribution unless the Trust first pays such Indicated Distribution (or the unpaid portion thereof) to holders of RBC TruCS — Series 2015. It is in the interest of the Bank to ensure, to the extent within its control, that the Trust pay the Indicated Distribution on the RBC TruCS — Series 2015 on each Regular Distribution Date so as to avoid triggering the Dividend Stopper Undertakings.
…
Each RBC TruCS — Series 2015 will be exchanged automatically (the ‘‘Automatic Exchange’’), without the consent of the holder, for 40 newly issued non-cumulative, perpetual First Preferred Shares, Series Z of the Bank (‘‘Bank Preferred Shares Series Z’’) if: (i) an application for a winding-up order in respect of the Bank pursuant to the Winding-Up and Restructuring Act (Canada) is filed by the Attorney General of Canada or a winding-up order in respect of the Bank pursuant to that Act is granted by a court; (ii) the Superintendent of Financial Institutions (Canada) (the ‘‘Superintendent’’) advises the Bank in writing that the Superintendent has taken control of the Bank or its assets pursuant to the Bank Act (Canada) (the ‘‘Bank Act’’); (iii) the Superintendent advises the Bank in writing that the Superintendent is of the opinion that the Bank has a riskbased Tier 1 Capital ratio of less than 5.0% or a risk-based Total Capital Ratio of less than 8.0%; (iv) the Board of Directors advises the Superintendent in writing that the Bank has a risk-based Tier 1 Capital ratio of less than 5.0% or a risk-based Total Capital Ratio of less than 8.0%; or (v) the Superintendent directs the Bank pursuant to the Bank Act to increase its capital or provide additional liquidity and the Bank elects to cause the Automatic Exchange as a consequence of the issuance of such direction or the Bank does not comply with such direction to the satisfaction of the Superintendent within the time specified therein (each, a ‘‘Loss Absorption Event’’).

The Bank Preferred Shares Series Z will pay semi-annual, non-cumulative per share cash dividends, as and when declared by the Board of Directors on the last day of June and December in each year (subject to adjustment on the first such payment date if the Bank Preferred Shares Series Z have been issued and outstanding for less than six months), equal to $0.60625.

The RBC TruCS — Series 2010, the RBC TruCS — Series 2011 and the RBC TruCS — Series 2015 rank pari passu on the distribution of the property of the Trust in the event of a termination of the Trust (together with the Bank as sole holder of the Special Trust Securities) and rank pari passu in respect of the Indicated Distributions payable on each series of RBC TruCS.

So the Series Z preferreds carry an indicative dividend of 4.85% of par, paid semi-annually (not quarterly!). That’s a reasonable rate, considering the date of issue. Certainly nothing extraordinary.

Now here’s something that will sound very familiar!

The Bank Preferred Shares Series Z will not be redeemable prior to December 31, 2010. On and after December 31, 2010, but subject to the provisions of the Bank Act and the prior approval of the Superintendent and the provisions described below under ‘‘Description of the Bank Preferred Shares Series Z — Restrictions on Dividends and Retirement of Shares’’, the Bank may redeem at any time all, or from time to time any part, of the outstanding Bank Preferred Shares Series Z, at the Bank’s option without the consent of the holder, by the payment of an amount in cash for each such share so redeemed equal to (i) $26.00 per share if redeemed on or prior to December 31, 2011; (ii) $25.75 per share if redeemed after December 31, 2011 and on or prior to December 31, 2012; (iii) $25.50 per share if redeemed after December 31, 2012 and on or prior to December 31, 2013; (iv) $25.25 per share if redeemed after December 31, 2013 and on or prior to December 31, 2014; or (v) $25.00 per share if redeemed after December 31, 2014, plus, in each case, all declared and unpaid dividends up to but excluding the date fixed for redemption.

And in addition there is language describing the Series Z that is substantially identical to the “Restrictions on Dividends and Retirement of Shares” for the Series E Preferreds, above.

Now let’s look at the redemption provisions for the TruCS:

Upon the occurrence of a Tax Event or a Capital Disqualification Event, in each case prior to December 31, 2010, the RBC TruCS — Series 2015 will be redeemable by the Trust at its option in whole (but not in part) without the consent of the holders thereof, upon at least 30 and not more than 90 days’ prior written notice by the Trustee and with Superintendent Approval for a cash amount per RBC TruCS — Series 2015 equal to the Early Redemption Price, being the greater of: (i) the Redemption Price; and (ii) a price per RBC TruCS — Series 2015 calculated to provide an annual yield thereon to December 31, 2015 equal to the Government of Canada Yield plus 0.195% determined on the Business Day immediately preceding the date on which the Trust has given notice of the redemption of the RBC TruCS — Series 2015 as a consequence of the exercise of the Trust Special Event Redemption Right plus the Unpaid Indicated Distribution (the ‘‘RBC TruCS — Series 2015 Canada Yield Price’’).
…
On December 31, 2010 and on any Distribution Date thereafter, the Trust may, at its option, redeem the RBC TruCS — Series 2015 in whole (but not in part) without the consent of the holders thereof, upon at least 30 and not more than 60 days’ prior written notice and with Superintendent Approval, for a cash amount per RBC TruCS — Series 2015 equal to: (i) the Early Redemption Price if the redemption occurs prior to December 31, 2015; or (ii) the Redemption Price if the redemption occurs on or after December 31, 2015.

The “Redemption Price” is par value. These are good provisions – or, at least, relatively good provisions, if a buyer has to give up some call rights! Very often there are provisions in Eurobonds and related instruments that a change in tax law can lead to redemption at par. This is contrary to the interests of the holder, since it might mean he gives up capital gain if interest rates have fallen. However, this prospectus specifies that the worst redemption price will be at a spread to Canadas – and a profitable spread compared to issue price at that. I’m OK with that provision.

What does all this boil down to? After all, you must suspect that after all this quotation I’m going to get to the point eventually, right?

• The bank has some incentive to redeem the TruCS on the intended date of December 31, 2015. After this date, the interest payable on the TruCS changes to BAs + 150bp. Given current conditions, this is far more than the rate at which the bank could otherwise raise money, but this will not necessarily always be the case:
  • The credit quality of the bank may have deteriorated to the point at which BAs + 150 bp is a pretty good deal. After all, prime is now 6.00% at RBC … BAs + 170 bp.
  • The curve could get steeper. These bonds are perpetual. A 0-30 term spread of 150bp is by no means unheard of.
  • I note that an RBC Floating Rate Note maturing in 2083 is quoted at 97bp over BAs.
• Income is better protected in the TruCS than in the Preferreds – if they stop paying interest on the TruCS, dividends on the prefs can’t be paid for about a year.
• Default on Principal has the same protection on TruCS as on preferreds. This assumes that default on principal will be preceeded by an automatic conversion of the TruCS to Series Z 1st preferreds, which are pari passu with regular preferreds.

And what does all this mean in terms of investment policy? Ah, for that you’ll have to wait for Part 3!

I had a refreshing look at some bank balance sheets today, comparing capital structures.

There’s a good explanation of just what Tier 1 Capital is in CIBC’s most recent MD&A:

We use a three-tiered approach to set market risk and stress limits on the amounts of risk that we can assume in our trading and non-trading activities, as follows:

• Tier 1 limits are our overall market risk and worst-case scenario limits.
• Tier 2 limits are designed to control the risk profile in each business.
• Tier 3 limits are at the desk level and designed to monitor risk concentration and the impact of book-specific stress events.

The rules for just what can be included in Tier 1 are set by the Office of the Superintendent of Financial Institutions Canada in, for instance PRINCIPLES GOVERNING INCLUSION OF INNOVATIVE INSTRUMENTS IN TIER 1 CAPITAL and more particularly in Banks/T&L A – Part I Capital Adequacy Requirements

Preferred Shares (Tier 1)

Preferred shares will be judged to qualify as tier 1 instruments based on whether, in form and in substance, they are:

• subordinated;
• permanent; and
• free of mandatory fixed charges.

Subordination
Preferred shares must be subordinated to depositors and unsecured creditors of the DTI. If preferred shares are issued by a subsidiary or intermediate holding company for the funding of the DTI and are to qualify for capital at the consolidated entity (non-controlling interest), the terms and conditions of the issue, as well as the intercompany transfer, must ensure that investors are placed in the same position as if the instrument was issued by the DTI.

Permanence
To ensure that preferred shares are permanent in nature, the following features are not permitted:

• retraction by the holder;
• obligation for the issuer to redeem shares;
• redemption within the first five years of issuance; and
• any step-up representing a pre-set increase at a future date in the dividend (or distribution) rate.

Any conversion other than to common shares of the issuer or redemption is subject to
supervisory approval and:

• redemption can only be for cash or the equivalent;
• conversion privileges cannot be structured to effectively provide either a redemption of or return on the original investment.

For example, an issue would not be considered non-cumulative if it had a conversion feature that compensates for undeclared dividends or provides a return of capital.
Free of Mandatory Fixed Charges
Preferred shares included in tier 1 capital are not permitted to offer the following features:

• cumulative dividends;
• dividends influenced by the credit standing of the institution;
• compensation to preferred shareholders other than a dividend; or
• sinking or purchase funds.

In addition, the non-declaration of a dividend shall not trigger restrictions on the issuer other than the need to seek approval of the holders of the preferred shares before paying dividends on other shares or before retiring other shares. Non-declaration of a dividend would not preclude the issuer from making the preferred shares voting or, with the prior approval of the Superintendent, making payment in common shares.

To conform to accepted practice, in the event of non-declaration of a dividend, approval of the holders of preferred shares may be sought before:

• paying dividends on any shares ranking junior to the preferred shares (other than stock dividends in any shares ranking junior to the preferred shares);
• redeeming, purchasing, or otherwise retiring any share ranking junior to the preferred shares (except out of the net cash proceeds of a substantially concurrent issue of shares ranking junior to the preferred shares);
• An increase over the initial rate after taking into account any swap spread between the original reference index and the new reference index.
• redeeming, purchasing or otherwise retiring less than all such preferred shares; or
• except pursuant to any purchase obligation, sinking fund, retraction privilege or
  mandatory redemption provisions attached to any series of preferred shares, redeeming,
  purchasing or otherwise retiring any shares ranking on a parity with such preferred
  shares.

Examples of Acceptable Features
Outlined below are examples of certain preferred share features that may be acceptable in tier 1 capital instruments:

• a simple call feature that allows the issuer to call the instrument provided the issue cannot be redeemed in the first five years and, after that, only with prior supervisory approval;
• a dividend that floats at some fixed relationship to an index or the highest of several indices, as long as the index or indices are linked to general market rates and not to the financial condition of the borrower;
• a dividend rate that is fixed for a period of years and then shifts to a rate that floats over an index, plus an additional amount tied to the increase in common share dividends if the index is not based on the institution’s financial condition and the increase is not automatic, not a step-up, nor of an exploding rate nature; and
• conversion of preferred shares to common shares where the minimum conversion value or the way it is to be calculated is established at the date of issue.

Examples of conversion prices are: a specific dollar price; a ratio of common to preferred share prices; and a value related to the common share price at time of conversion.
Examples of Unacceptable Features
Examples of preferred share features that will not be acceptable in tier 1 capital are:

• an exploding rate preferred share, where the dividend rate is fixed or floating for a period and then sharply increases to an uneconomically high level;
• an auction rate preferred share or other dividend reset mechanism in which the dividend is reset periodically based, in whole or part, on the issuer’s credit rating or financial condition; and
• a dividend-reset mechanism that does not specify a cap, consistent with the
  institution’s credit quality at the original date of issue.

I’ll write more on this later. I’m really just organizing my thoughts on this matter and getting my ducks in a row for an article!