PrefBlog

There is an issue with Reverse Mortgages, to wit:

Reverse mortgages more closely resemble investments in real estate than they do residential mortgages as defined in the Basel Framework. Reverse mortgages are limited recourse loans – the lender looks solely to the residential property securing the loan for repayment of principal, accrued interest and costs. Assuming there is no event of default, the amount recovered on a reverse mortgage is capped at the fair market value of the home at the time it is sold and the lender has no recourse to the borrower for any shortfalls.

In contrast, a residential mortgage is, first of all, an exposure to an individual person secured by recourse to a residential property. The lender has recourse to the borrower for any shortfalls or deficiencies in property value.

Nevertheless, under appropriately conservative conditions, a large number of reverse mortgages should be able to qualify for the 35% qualifying residential mortgage risk weight under the Standardized Approach. We are proposing that only the Standardized Approach be made available for this type of lending, as this is consistent with the treatment observed in other Basel member countries.

OSFI has proposed the following table of capital charges is (LTV = Loan-to-Value):

The treatment of “sub-prime reverse mortgages” (current LTV > 85%) is:

Where a reverse mortgage exposure has a current LTV greater than 85%, the exposure amount that exceeds 85% LTV is deducted from capital. The remaining amount is riskweighted at 100%.

The Treasury Board of Canada Secretariat has released its report card on OSFI’s performance in 2007-08.

It is without value. Despite the admission that (bolding added):

Primary to OSFI’s mission and central to its contribution to Canada’s financial system are two strategic outcomes:

• To regulate and supervise to contribute to public confidence in Canada’s financial system and safeguard from undue loss. OSFI safeguards depositors, policyholders and private pension plan members by enhancing the safety and soundness of federally regulated financial institutions and private pension plans.
• To contribute to public confidence in Canada’s public retirement income system

… OSFI’s success in meeting the objectives of interest to investors was determined by:

OSFI provided The Strategic Counsel, an independent research firm, with a list of CEOs of federally regulated financial institutions. The research firm invited the CEOs to participate in either an online or a telephone survey, and 166 (61%) participated. OSFI does not know which CEOs participated. The complete report is available on OSFI’s Web site under Organization / Reports/ Consultations and Surveys.

Yup, the people who can put me out of business tomorrow are doing just a fine job, no question, yup.

OSFI has advised that it:

is in the process of revising Guideline B-6 on Liquidity to take account of the Principles recommended by the Basel Committee and to incorporate any additional guidance that is appropriate for domestic application. Similar deliberations are taking place across jurisdictions through the BCBS and other regulatory fora. A consultation draft of the revised Guideline is targeted for release in the summer of 2009.

There is, surprisingly, a request for submissions:

As part of our development of new guidance on liquidity, OSFI welcomes submissions as to how to best give effect to the BCBS Principles on a consistent and measurable basis.

… but no indication that these submissions will be publicly disclosed and discussed.

The Basel Committee on Banking Supervisions’s September ’08 Principles for Sound Liquidity Risk Management and Supervision include:

Principle 13: A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgement about the soundness of its liquidity risk management framework and liquidity position.

… with the exhortation:

As part of its periodic financial reporting, a bank should provide quantitative information about its liquidity position that enables market participants to form a view of its liquidity risk. Examples of quantitative disclosures currently disclosed by some banks include information regarding the size and composition of the bank’s liquidity cushion, additional collateral requirements as the result of a credit rating downgrade, the values of internal ratios and other key metrics that management monitors (including regulatory metrics that may exist in the bank’s jurisdiction), the limits placed on the values of those metrics, and balance sheet and off-balance sheet items broken down into a number of short-term maturity bands and the resultant cumulative liquidity gaps. A bank should provide sufficient qualitative discussion around its metrics to enable market participants to understand them, eg the time span covered, whether computed under normal or stressed conditions, the organisational level to which the metric applies (group, bank or non-bank subsidiary), and other assumptions utilised in measuring the bank’s liquidity position, liquidity risk and liquidity cushion.

As an example of current reporting the RBC 2008 Annual Report contains a three page section (pp. 109-112 of the report, 111-114 of the PDF) on liquidity risk, comprised largely of ‘don’t worry, trust us’ blather and precious little quantitative data.

The Office of the Superintendant of Financial Institutions has announced that it:

is releasing a revised Minimum Continuing Capital and Surplus Requirements (MCCSR) Guideline and four advisories.
“OSFI reviews its regulatory capital framework on a regular basis to protect depositors and policyholders by ensuring financial institutions maintain adequate capital levels while reflecting the risks and market conditions that financial institutions face in a competitive global marketplace,” says Robert Hanna, Assistant Superintendent, Regulation Sector.

To help achieve this balance, revisions are being made to the MCCSR Guideline, which sets the capital rules for the federally regulated life insurance industry. In addition, three new advisories that focus on life insurance capital are being issued.

Late on Christmas eve is a classic time for private companies to release things like profit warnings … things they are required to release, but which they hope will evade careful scrutiny.

In a speech given on November 18, OSFI Superintendant Julia Dickson said:

With the new found appreciation for capital, everyone is asking what capital level is enough, particularly in the banking sector, which has been in the eye of the storm. While it is difficult to do a comparison of capital ratios across global life companies (due to differences in nomenclature and approach), it is easier to do in the banking sector, and that has been the focus of much attention.

What we see in a comparison of international banks against Canadian banks is that our big five banks went into the turmoil with high capital levels (and we would say the same about life companies). Bank Tier 1 ratios at Q3 2008 ranged from 9.47 per cent to 9.81 per cent. This compared to Tier 1 ratios at other global banks that often started with the digits 6, 7 and 8 (versus 9 in Canada).

If you look at what is contained in Tier 1 — as they say, never judge a book by its cover — you will find that Canadian banks have platinum quality Tier 1 when compared to banks in other countries. The percentage of common shares is skyhigh, something not replicated in other places around the world.

Capital injections from governments into other global banks have tended to be in preferred shares (and sometimes preferred shares with step-ups or incentives to redeem that detract from their permanence, and permanence is a critical element for OSFI to consider something as Tier 1 capital). Canadian bank Tier 1 common ratios at Q3 2008 tended to be in the high 7s or low 8s. Elsewhere in the world the ratios were typically 5, 6, and low 7s.

To summarize, quality, and level of capital, are equally important and the market needs to focus on that. Going forward, there is going to be an incredible amount of attention paid by regulators internationally on the level and quality of capital. I believe Canada is well placed to enter those discussions. I also think that decisions will likely only be taken once world economies strengthen, and financial institutions will be given plenty of advance notice regarding new requirements.

The increase in the Tier 1 preferred limit has been discussed on PrefBlog. It does seem rather odd to me that OSFI is exalting the high quality of bank capital while at the same time permitting its debasement. There’s not necessarily a contradiction here, but there is definitely a need for a wee bit of discussion on the point.

Now, in the face of media frenzy, OSFI has released a note of calm:

Recent media reports regarding the Office of the Superintendent of Financial Institutions’ (OSFI) position on capital ratio levels may have led to some confusion. On Friday, December 19, 2008, OSFI provided the following information to the media:
OSFI’s views on capital were outlined in a speech given by Superintendent Julie Dickson on November 13, 2008, and those views have not changed.

In that speech, the Superintendent made a number of points, among them, that Canadian banks remain well capitalized. It noted that common equity ratios of the large banks are particularly high, and that markets ought to consider this in their views about capital adequacy. This point was made because markets were demanding that Canadian banks increase capital, possibly based on a simple comparison of Tier 1 levels across global banks, even though many global banks have had capital injections from governments.

Further, it was noted that banks should not engage in share buy-backs without first clearing it with OSFI, as capital needed to be managed conservatively. Managing capital conservatively does not mean increasing capital.

OSFI has discussed global market developments both with banks and international regulators, as a similar phenomenon of markets taking a view on capital and driving up capital levels, is being observed globally. At the same time, to the extent banks have met market expectations regarding capital, this makes Canadian banks well-positioned to continue to lend.

As well, OSFI has increased flexibility within its rules by increasing the preferred share limit to 40 per cent from 30 per cent, which reduces the cost of capital for financial institutions, and may further support lending.

In short, OSFI has not pushed for higher capital ratios across the board, and OSFI agrees that capital is a cushion that should be available to be drawn down when faced with unexpected losses.

Another hot tip from Assiduous Reader tobyone leads to more musings from Barry Critchley of the Financial Post:Flurry of Share Offerings:

And it seems OSFI is interested in other types of securities that would constitute Tier 1 capital. In yesterday’s column we mused the market was speculating that soft retractable pref shares — which used to count as Tier 1 capital before OSFI ruled to make them Tier 2 capital — would be on the list. The chance of such a return is low if issuers are talking about the former type of soft retractables. (OSFI ruled against them in part because of the potentially huge increase in common shares outstanding, in the rare event that the issuer opted to pay in stock and not cash.) However, if they come with new bells and whistles, then OSFI may be interested — but only after the security has undergone the normal review process. “Part of OSFI’s mandate is to see what they come up with and figure out if it works or not,” said the OSFI spokesperson.

One type of pref share that may cut the mustard is convertible pref shares.

An OSFI spokesperson said it would be interested in such a security counting as Tier 1 capital “if it had the right kind of features for capital. Convertibles is something that’s been floated. It has been discussed,” added the spokesperson, noting that issues of mandatory convertible prefs, are part of Tier 1 capital in some countries.
…
What else could OSFI be looking at?

Underwriters report that issuers would like an increase in the percentage of Tier 1 capital allocated to innovative instruments. Currently 15% of Tier 1 capital can be in the form of such securities. But that percentage hasn’t changed — despite the recent 10-percentage-point increase, to 40%, in the share of preferred shares in Tier 1 capital. (At the start of the year, the percentage was 25%, meaning a 15-percentage-point increase for the year.)

“Investors are more interested in taking the 15% stake up to 25% because the innovative Tier 1 market is an institutional market,” said one market participant, noting that the change would allow larger issues, certainly larger than issues of rate reset preferred shares which are largely bought by retail investors.

Mandatory convertibles have certain advantages for all issuers:

A relatively large proportion of convertibles are currently issued as mandatory convertibles. A mandatory convertible is automatically converted into equity at a specific maturity date, thus removing the optionality for the buyer of the convertible. The transfer of risk to the buyer is usually compensated by a higher yield. Companies want to issue mandatory
convertibles in order to avoid their experiences of 1999 and 2000, when many telecoms companies issued convertibles in the expectation that they would be converted into equity at the time of redemption. In most cases the conversion did not take place due to the sharp decline in equity prices, leaving them with much higher than expected debt/equity ratios. Another attractive feature for the issuer of mandatory convertibles is that they are in general not treated by the rating agencies as pure debt. The biggest mandatory convertible issues in the
first quarter of 2003 were a €2.3 billion offering by Deutsche Telekom and one of ¥345 billion ($2.9 billion) by Sumitomo Mitsui Financial Group.

As far as BIS is concerned, banking implications of convertible preferreds are (largely?) limited to the United States

Cumulative preference shares, having these characteristics, would be eligible for inclusion in [Tier 2]. In addition, the following are examples of instruments that may be eligible for inclusion: long-term preferred shares in Canada, titres participatifs and titres subordonnés à durée indéterminée in France, Genusscheine in Germany, perpetual subordinated debt and preference shares in the United Kingdom and mandatory convertible debt instruments in the United States.

… but I note a recent issuance by UBS:

At UBS, the government package provided significant relief to the balance sheet from the burden of illiquid positions particularly affected by the crisis. With this package, the SNB made it possible for UBS to transfer illiquid positions to a special purpose vehicle. The UBS provided this special purpose vehicle with equity amounting to USD 6 billion. The Confederation compensated UBS for the capital requirement arising for this purpose by subscribing to mandatory convertible notes (MCN). Since the announcement of the package, the UBS liquidity situation has stabilised.

The recent issue by Morgan Stanley gives an important clue as to the value of Convertible Preferreds in times of stress:

Under the revised terms of the transaction, MUFG has acquired $7.8 billion of perpetual non-cumulative convertible preferred stock with a 10 percent dividend and a conversion price of $25.25 per share, and $1.2 billion of perpetual non-cumulative non-convertible preferred stock with a 10 percent dividend.
…
Half of the convertible preferred stock automatically converts after one year into common stock when Morgan Stanley’s stock trades above 150 percent of the conversion price for a certain period and the other half converts on the same basis after year two. The non-convertible preferred stock is callable after year three at 110 percent of the purchase price.

With other examples from Citigroup, we may conclude that Convertible Preferreds can be very useful in times when the common dividend is in doubt, or is otherwise thought to be insufficient for the risk of holding the common.

The Federal Reserve allows inclusion of convertible preferreds in Tier 1 in a manner analogous to the Canadian treatment of perpetuals:

The Board has also decided to exempt qualifying mandatory convertible preferred securities from the 15 percent tier 1 capital sub-limit applicable to internationally active BHCs. Accordingly, under the final rule, the aggregate amount of restricted core capital elements (excluding mandatory convertible preferred securities) that an internationally active BHC may include in tier 1 capital must not exceed the 15 percent limit applicable to such BHCs, whereas the aggregate amount of restricted core capital elements (including mandatory convertible preferred securities) that an internationally active BHC may include in tier 1 capital must not exceed the 25 percent limit applicable to all BHCs.

Qualifying mandatory convertible preferred securities generally consist of the joint issuance by a BHC to investors of trust preferred securities and a forward purchase contract, which the investors fully collateralize with the securities, that obligates the investors to purchase a fixed amount of the BHC’s common stock, generally in three years. Typically, prior to exercise of the purchase contract in three years, the trust preferred securities are remarketed by the initial investors to new investors and the cash proceeds are used to satisfy the initial investors’ obligation to buy the BHC’s common stock. The common stock replaces the initial trust preferred securities as a component of the BHC’s tier 1 capital, and the remarketed trust preferred securities are excluded from the BHC’s regulatory capital [footnote].

Allowing internationally active BHCs to include these instruments in tier 1 capital above the 15 percent sub-limit (but subject to the 25 percent sub-limit) is prudential and consistent with safety and soundness. These securities provide a source of capital that is generally superior to other restricted core capital elements because they are effectively replaced by common stock, the highest form of tier 1 capital, within a few years of issuance. The high quality of these instruments is indicated by the rating agencies’ assignment of greater equity strength to mandatory convertible trust preferred securities than to cumulative or noncumulative perpetual preferred stock, even though mandatory convertible preferred securities, unlike perpetual preferred securities, are not included in GAAP equity until the common stock is issued.

Nonetheless, organizations wishing to issue such instruments are cautioned to have their structure reviewed by the Federal Reserve prior to issuance to ensure that they do not contain features that detract from its high capital quality.

Footnote: The reasons for this exclusion include the fact that the terms of the remarketed securities frequently are changed to shorten the maturity of the securities and include more debt-like features in the securities, thereby no longer meeting the characteristics for capital instruments includable in regulatory capital.

Section 4060.3.9.1 of the Fed’s Bank Holding Company Supervision Manual extends this treatment to convertible preferreds that convert to perpetual non-cumulative preferreds.

I have no problem from a public policy perspective of allowing the inclusion of Convertible Preferreds into Tier 1 capital, provided they meet the basic requirements of subordination and the potential for having their income suspended on a non-cumulative basis without recourse for the holders.

If such are issued, however, they will almost certainly not be included in the HIMIPref™ database, as there is considerable potential for such issues to “sell off the stock”. In fact, I would consider such issues – in the absence of even more innovation – to be equivalent to common stock with a bonus dividend; not fixed income at all.

I have a much bigger problem with the second proposal in Mr. Critchley’s column – the expansion of the Innovative Tier 1 limit to 25% from its current 15%. I will not accept that further debasement of bank credit quality is justified by prior debasement; let’s see a little more analysis and stress-testing than that!

Barry Critchley writes in today’s Financial Post:

Are so-called soft retractable preferred shares — a security that allows the issuer, at maturity, to pay in common shares or cash– the next type of Tier 1 capital financial institutions will be allowed to issue as part of the overall thrust of strengthening their balance sheets?

There is talk that the federal regulator, the Office of the Superintendent of Financial Institutions (OSFI), has been approached.
…
Soft retractables come with features that make them akin to Tier 1 or permanent capital: They are noncumulative in relation to dividends, and they have a term to maturity that can be extended to perpetuity if the issuer decides to pay not in cash but in common shares. (If that did happen, the pref share issue would be dilutive.) And they have the ability to absorb losses. But rule changes a few years back mean the capital raised now counts as Tier 2 capital. Accordingly, they receive the same treatment as debt securities. Since those changes were implemented, no financial institution has issued soft retractables. “If you have soft retractables that count as debt and are dilutive, it’s the worst of both worlds,” noted one underwriter, who added OSFI has “never really liked soft retractables.”
…
So how could OSFI make soft retractables more attractive for financial institutions to issue? The easiest way would be to overlook recent accounting changes and have the capital raised count as equity, not as debt.
…
Certainly institutional investors would like the regulators to change the rules to allow soft retractables to count as Tier 1 capital. Institutions would be buying a term security, a feature that allows them to match the investment against a liability.

The crux of the issue is the last paragraph: pretend-managers wanting securities with pretend-maturities … just like Deutsche Bank’s sub-debt! I will certainly not deny that, should there be new bank OpRet issues, they will be included in the HIMIPref™ portfolio and they will be considered for recommendation to clients.

But from a public policy perspective, these issues would be a disaster. In times of trouble they will be dilutive to the shareholders and get the bank into even more trouble – as has happened recently with the Quebecor World issue, IQW.PR.C. This is not what tier 1 capital is supposed to do!

Tier 1 Capital must participate in losses and must not be procyclical – that seems to me to be quite intuitive. There has been quite enough debasement of bank capital quality recently, with the recent approval of a rule to allow cumulative innovative Tier 1 Capital.

Such tinkering may well meet the objective of decreasing the probability of trouble, by increasing the funding sources available for Tier 1 capital. But the piper must eventually be paid: the corollary is that in times of trouble you increase the potential for crowded trades and cliff risk.

Hat Tip: Assiduous Reader tobyone.

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!

The Basel Committee has announced:

a comprehensive strategy to address the fundamental weaknesses revealed by the financial market crisis related to the regulation, supervision and risk management of internationally-active banks.
…
The key building blocks of the Committee’s strategy are the following:

• strengthening the risk capture of the Basel II framework (in particular for trading book and off-balance sheet exposures);
• enhancing the quality of Tier 1 capital;
• building additional shock absorbers into the capital framework that can be drawn upon during periods of stress and dampen procyclicality;
• evaluating the need to supplement risk-based measures with simple gross measures of exposure in both prudential and risk management frameworks to help contain leverage in the banking system;
• strengthening supervisory frameworks to assess funding liquidity at cross-border banks;
• leveraging Basel II to strengthen risk management and governance practices at banks;
• strengthening counterparty credit risk capital, risk management and disclosure at banks; and
• promoting globally coordinated supervisory follow-up exercises to ensure implementation of supervisory and industry sound principles.

[Chairman of the Basel Committee ] Mr Wellink further noted that the Basel Committee expects to issue proposals on a number of these topics for public consultation in early 2009, focusing on the April 2008 recommendations of the Financial Stability Forum. The other topics will be addressed over the course of 2009

Interesting. It looks like a repudiation of OSFI’s debasement of Bank Capital, an intent to look at the internationally controversial leverage ratio (or Assets to Capital Multiple, in Canada), and … I don’t know: a threat (? depends on what “leveraging” means) to regulate bonuses (? depends on what “governance” means).

OSFI should take careful note of the intent “to issue proposals on a number of these topics for public consultation”. That’s how the professionals do things, guys.

OSFI has yet again kicked investors in the teeth with a new advisory and accompanying letter. The advisory states:

As set out in the CAR and MCCSR guidelines and related advisories, OSFI currently allows certain high quality preferred shares to be included in Tier 1 capital (Tier 1 capital is the highest quality capital and includes retained earnings, common shares, high quality preferred shares such as perpetual preferred shares, as well as innovative instruments). As set out in the January 2008 Advisory, the sum of Tier 1-qualifying preferred shares and innovative instruments included in Tier 1 capital is limited to no more than 30% of net Tier 1 capital.

To provide FREs with added flexibility to maintain their strong capital positions, OSFI is increasing this 30% limit to 40%, effective immediately. The requirements that preferred shares must meet to qualify as Tier 1 capital, as per the MCCSR or CAR Guidelines and related advisories, (e.g. permanence, subordination and absence of fixed charges) remain unchanged and are fully compliant with the principles enunciated by the Basel Committee on Banking Supervision for Tier 1 capital.

Should the 40% limit be exceeded at any time, FREs must notify OSFI and provide a detailed plan, acceptable to OSFI, to regain compliance with such limit5. At a minimum, such a plan should work towards the restoration of the desired balance between Tier 1 capital components by not increasing dividends or buying back common shares, unless OSFI otherwise agrees.

… and this is highlighted by the letter:

Second, the aggregate limit on Tier 1-qualifying preferred shares and innovative instruments included in Tier 1 capital is being increased from 30% to 40%, effective immediately. This advisory will update the January 2008 Advisory: Aggregate Limit on Tier 1-qualifying Preferred Shares and Innovative Instruments.

These initiatives reflect recent developments in global financial markets. These changes should assist Canada’s financial institutions in maintaining their position of strength when compared to their international competition.

This appears to degrade the quality of Canadian Tier 1 capital relative to the the United States, where, in 2005:

The final Fed rule allows BHCs to “explicitly” include outstanding and prospective issuance of these securities in their Tier 1 capital. However, the Fed will also subject these instruments and other “restricted core capital elements” to tighter quantitative limits within Tier 1, and more stringent qualitative standards. Trust preferred securities and other restricted elements will continue to be limited to 25% ceiling within Tier 1. A lower ceiling of 15% will be set for internationally active BHCs. Previously this 15% ceiling had only been a recommendation not a firm rule.
…
Much of what is in the final rule is unchanged from the Fed’s proposal of last May (see June issue of Global Risk Regulator), when public comments were sought. The Federal Reserve notes that, of the 38 comment letters received, the letter from the FDIC is the only one to oppose the rule. For its part, however, the FDIC does not pull its punches. “Trust preferred securities do not provide the degree of capital support that is consistent with their receiving the Tier 1 designation that is reserved for high-quality capital instruments,” writes Chairman Powell. “We are also concerned that the Federal Reserve has, in effect, used its exclusive authority over BHC capital requirements to confer a competitive advantage on BHC subsidiaries relative to stand-alone banks,” Powell adds.

OSFI’s action may be intended as a counter to the Interim Final Rule of October 16:

The Federal Reserve Board on Thursday announced the adoption of an interim final rule that will allow bank holding companies to include in their Tier 1 capital without restriction the senior perpetual preferred stock issued to the Treasury Department under the capital purchase program announced by the Treasury on October 14, 2008.
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The interim rule will be effective as of October 17, 2008. The Board is, however, seeking public comment on the interim rule. Comments must be submitted within 30 days of publication of the interim rule in the Federal Register, which is expected soon.

The draft Federal Register notice states:

The aggregate amount of Senior Perpetual Preferred Stock that may be issued by a banking organization to Treasury must be (i) not less than one percent of the organization’s risk-weighted assets, and (ii) not more than the lesser of (A) $25 billion and (B) three percent of its risk-weighted assets. Treasury expects the issuance and purchase of the Senior Perpetual Preferred Stock to be completed no later than December 31, 2008.

To be eligible for the Capital Purchase Program, the Senior Perpetual Preferred Stock must include several features, which are designed to make it attractive to a wide array of generally sound banking organizations and encourage such banking organizations to replace the Senior Perpetual Preferred Stock with private capital once the financial markets return to more normal
conditions.

In particular, the Senior Perpetual Preferred Stock will have an initial dividend rate of five percent per annum, which will increase to nine percent per annum five years after issuance. In addition, the stock will be callable by the banking organization at par after three years from issuance and may be called at an earlier date if the stock will be redeemed with cash proceeds from the banking organization’s issuance of common stock or perpetual preferred stock that (i) qualifies as Tier 1 capital of the organization and (ii) the proceeds of which are no less than 25 percent of the aggregate issue price of the Senior Perpetual Preferred Stock. In all cases, the redemption of the Senior Perpetual Preferred Stock will be subject to the approval of the banking organization’s appropriate Federal banking agency. In addition, following the redemption of all the Senior Perpetual Preferred Stock, a banking organization shall have the right to repurchase any other equity security of the organization (such as warrants or equity securities acquired through the exercise of such warrants) held by Treasury.

There is a commentary by Jones, Day on the web.

OSFI’s astonishing action has the potential to decrease the subordination of Preferred Shares in the capital structure; exposing them to higher risk of loss and making them more equity-like. Investors will have to pay increased attention to the Equity / Risk Weighted Assets Ratio than they have in the past.