Archive for the ‘Contingent Capital’ Category

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

Tuesday, August 29th, 2023

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:

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!

NVCC & Credit Suisse

Monday, March 20th, 2023

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.

OSFI Revises Rules for LRCNs; Finally Provides Information for Insurers

Friday, March 19th, 2021

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

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.

LRCN Issuance Cap Floor
AT1 Greater of $150 million, 0.75%
RWA, or 50% of the
institution’s aggregate net AT1
Lesser of 0.30% RWA or 20% of
the institution’s aggregate AT1
Life Tier 1 Capital
other than
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.

IAIS Says No To DeemedRetractions

Thursday, November 14th, 2019

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.

IAIS Releases ICS 2.0 Consultation Comments

Friday, April 5th, 2019

The International Association of Insurance Supervisors has released the comments received to its 2018 ICS 2.0 Consultation. Assiduous Readers will remember that the comment period closed at the end of October, 2018 and included the following questions that are critical to the question of Deemed Maturities for Insurance issues:

The consultation document, downloadable from the above page, contains the critical (for our purposes) question:

173. The IAIS is considering whether to set an additional criterion requiring Tier 1 Limited instruments to have a principal loss absorbency mechanism (PLAM). Such mechanisms would provide a means for financial instruments to absorb losses on a going-concern basis through reductions in the principal amount and cancellation of distributions. Without such mechanisms these instruments might only provide going concern loss absorbency through cancellation of distributions.

Click for Big

The consultation document, and the files with respondents’ answers to the questions, may be downloaded from the IAIS Insurance Capital Standards page. The ‘critical questions’, ##52-54, are found in Section 6 Reference ICS – Capital resources (public). The IAIS notes that:

The IAIS received 56 submissions in response to the 2018 ICS Consultation Document of which 18 were requested by the respondents to be kept confidential. Therefore, the comments that are posted here publicly are a subset of those that the IAIS will be taking into account as it moves forward with the ICS.

Q52 Section 6 Is a PLAM [Principal Loss Absorbency Mechanism] an appropriate requirement for Tier 1 Limited financial instruments? Please explain any advantages and disadvantages of requiring a PLAM.

There were 17 responses, 8 yes and 9 no.

OSFI answered “No”:

A PLAM is one option considered to assess loss absorbency in a going concern. However, OSFI’s view is that PoNV (point of non viability) loss absorbency could also be considered. Specifically, the IAIS could consider loss absorbency on a going concern basis, as well as on a gone concern basis with contractual or statutory) PoNV triggers. It is possible that an insurer could fail before a PLAM trigger occurs due to the lagging nature of PLAM triggers. Moreover, PLAM triggers could have adverse signalling effects in respect of the financial condition of the issuer, which could precipitate non-viability.

This advocacy of ‘point of non viability loss absorbency’ is consistent with the NVCC rules OSFI has imposed on banks and with its answer to the 2016 consultation. Assiduous readers will remember that I consider the ‘adverse signalling effects’ of a PLAM trigger to be a feature, not a bug; high triggers are good things, and I’m not the only one who says so:

Moreover, high-trigger CoCos would presumably get converted not infrequently which, in terms of reducing myopia in capital markets, would have the merit of reminding holders and issuers about risks in banking.

Broadly speaking, Europeans were in favour of PLAM, although some expressed concerns about complexity: China Banking and Insurance Regulatory Commission (CBIRC); European Insurance and Occupational Pensions Authority (EIOPA); Insurance Europe; Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); General Insurance Association of Japan; Financial Supervisory Service (FSS) & Financial Services Commission (FSC); Legal & General; Association of British Insurers. Comments included EIOPA’s remark:

Requiring a PLAM, i.e. write-down or conversion features, provides a means for the principal of a financial instrument to absorb losses on a going-concern basis. Without such mechanisms these instruments only provide going concern loss absorbency through cancellation of distributions.

Naysayers were dominated by American regulators and firms: Dai-ichi Life Holdings, Inc., American Council of Life Insurers, National Association of Mutual Insurance Companies; Prudential Financial, Inc.; American Property Casualty Insurance Association (APCI); MetLife, Inc; Property Casualty Insurers Association of America (PCI); and the National Association of Insurance Commissioners (NAIC). The Americans have a high degree of concern regarding the continued eligibility of “surplus notes”, as exemplified by the response of the National Association of Mutual Insurance Companies:

PLAM is an addition to the discussion that NAMIC strongly opposes. NAMIC does not see any value in a PLAM requirement. It is simply a way to further complicate the ICS 2.0 providing no value. It seems to be designed to reduce the value of allowing surplus notes to qualify as Tier 1 capital resources.

The elephant in the room is AIG and the European bank bail-outs that left Tier 1 noteholders unscathed, at least relatively. How can anybody say with a straight face that loss absorbency via cessation of dividends is sufficient in the face of those memories?

Q53 Section 6 If a PLAM requirement is not introduced, what amount should be included in ICS capital resources for instruments that qualify as Tier 1 Limited, to reflect going concern loss absorbency? Please explain.

OSFI’s answer is a disgrace:

Capital composition limits address the concerns related to loss absorbency of Tier 1 Limited instruments and therefore their full face amount should be included in the ICS capital resources.

In other words, OSFI would have us believe that since Limited Tier 1 Capital is a limited proportion of the insurers’ high quality capital, it doesn’t really matter whether it’s actually high quality or not. Disgusting.

EIOPA and BaFin stepped into the breach:

Without a PLAM requirement, it is difficult to see how the principal of an instrument absorbs losses in a going concern basis.

Interestingly, the Property Casualty Insurers Association of America (PCI) stated:

In support, PCI cites the response of OSFI-Canada to a similar question in the prior ICS consultation

and quoted in full the dovish response to the 2016 consultation … including the grudging support for a NVCC solution.

Others stated that cessation of distributions worked just fine, e.g., American Property Casualty Insurance Association (APCI):

Tier 1 Limited instruments already provide loss absorbency on a going concern loss basis through cancellation of distributions. Reducing the principal amount of these instruments is only necessary during resolution.

Q54 Section 6 Are there other criteria that could be added to enhance the ability of financial instruments to absorb losses on a going concern and / or on a gone concern basis? Please explain.

OSFI had nothing to say. BaFin and EIOPA had identical answers again:

• In T1, mandatory cancellation of distributions on breach of capital requirement (i.e. a lock-in feature).
• In T2, mandatory deferral of distributions and redemption of principal on breach of capital requirement (i.e. a lock-in feature).
• Requirement for early repurchase (within 5 years from issuance) to be funded out of proceeds of new issuance of
same/higher quality (all tiers).

I don’t quite understand this response. Does “cancellation” mean cancellation forever and ever on T1, as opposed to a temporary “deferral” on T2? How about redemptions? Would such instruments have any rights if the issuer actually did go bankrupt ten years later? And I don’t understand what they mean by an early purchase requirement at all.

So, there you have it. I don’t find anything particularly surprising here; there might be some meaning behind the heavy American participation in this consultation, but an outsider such as myself would be foolish to speculate on just what that meaning might be.

DBRS: Canadian Banks’ Trends Now Stable on Bail-In Approval

Wednesday, April 25th, 2018

DBRS has announced that it has:

changed the trend to Stable from Negative on the Long-Term Issuer Ratings, Senior Debt Ratings and Deposits ratings of the Bank of Montreal, The Bank of Nova Scotia, the Canadian Imperial Bank of Commerce and the National Bank of Canada. These actions result from the publication by the Minister of Finance of the final rules related to the Bank Recapitalization Regime (the Bail-in Regime). DBRS notes that the Stable trends on the long-term ratings of The Toronto-Dominion Bank and Royal Bank of Canada were unaffected. For these domestic systemically important banks (D-SIBs) to which the Bail-in Regime is applicable, DBRS has created a new obligation named Bail-inable Senior Debt. This new obligation rating reflects the senior debt that these banks will begin issuing once the Bail-in Regime goes into effect on September 23, 2018. Lastly, DBRS has downgraded the legacy Subordinated Debt ratings of these D-SIBs by one notch.

The revision of the trend to Stable from Negative for the affected long-term ratings reflects DBRS’s view that a downgrade of existing senior debt for the D-SIBs is now unlikely. It is anticipated that systemic support would still be sufficient to add a notch for such support until the D-SIBs issue adequate amounts of Bail-inable Senior Debt to meet their total loss-absorbing capacity (TLAC) requirements. Once an adequate level of bail-inable debt has been issued, the likelihood of future systemic support would be much lower. Accordingly, the notch of support would then be withdrawn. However, the new Bail-inable Senior Debt creates an additional buffer that better protects all senior obligations that cannot be bailed in under the regulation. Therefore, DBRS does not expect to downgrade any long-term ratings of existing senior obligations of the D-SIBs.

When issued, DBRS will rate the new Bail-inable Senior Debt at the level of each bank’s Intrinsic Assessment (IA), reflecting the risk of a D-SIB being put into resolution.

The downgrades of the legacy Subordinated Debt ratings reflect the structural subordination to the Bail-inable Senior Debt.

This has been telegraphed for a long, long time:

S&P Revises Bank Outlook to Stable on Federal Complacency

Saturday, December 12th, 2015

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.

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.

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.

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:







Update On OSFI Insurer Regulation

Thursday, December 10th, 2015

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.

No CoCos, Please, We’re British

Tuesday, August 5th, 2014

Retail investors in the UK have been barred from buying Contingent Capital instruments:

The U.K.’s Financial Conduct Authority will ban firms from selling contingent convertible bonds to individual investors, saying they’re too complex and risky for the mass retail market.

From Oct. 1, the FCA will limit sales of CoCos to institutional, professional investors and high-net-worth individuals for 12 months, the London-based regulator said in a statement today. The FCA will publish a consultation paper on a set of permanent set of rules for CoCos in September.

“In a low interest rate environment, many investors might be tempted by CoCos offering high headline returns,” Christopher Woolard, the FCA’s director of policy, risk and research, said in a statement today. “However, they are complex and can be highly risky.”

“Every time a bank gets into trouble and you have retail investors in subordinated debt or CoCos, it gets difficult and embarrassing for the regulators,” said Mark Taber, who helped organize a group of individual holders of Co-Operative Bank Plc bonds when the British lender was restructured following a capital shortfall. “They don’t want to have that problem every time that happens. They want to be able to deal with banks.”

Their press release states:

Temporary product intervention rules are made without prior consultation and thus will not undergo the usual process for testing draft rules and receiving feedback from the public before they are made. While every effort has been made to ensure these temporary rules have the effect described in this communication, we remain aware of the possibility of unintended consequences.

In a linked document the European Securities and Markets Authority acknowledges (emphasis added):

Investors should fully understand and consider the risks of CoCos and correctly factor those risks into their valuation. To correctly value the instruments one needs to evaluate the probability of activating the trigger, the extent and probability of any losses upon trigger conversion (not only from write-downs but also from unfavourably timed conversion to equity) and (for AT1 CoCos) the likelihood of cancellation of coupons. These risks may be highly challenging to model. Though certain risk factors are transparent, e.g., trigger level, coupon frequency, leverage, credit spread of the issuer, and rating of instrument, if any, other factors are discretionary or difficult to estimate, e.g. individual regulatory requirements relating to the capital buffer, the issuers’ future capital position, issuers’ behaviour in relation to coupon payments on AT1 CoCos, and any risks of contagion. A comprehensive appreciation of the value of the instrument also needs to consider the underlying loss absorption mechanism and whether the CoCo is a perpetual note with discretionary coupons (AT1 CoCos) or has a stated maturity and fixed coupons (T2 CoCos). Importantly, as one descends down the capital structure to sub-investment grade where the majority of CoCos sit, the level of precision in estimating value when compared to more highly rated instruments, deteriorates. ESMA believes that this analysis can only take place within the skill and resource set of knowledgeble institutional investors.

The FCA action comes at a time when investor appetite is very high:

Denmark may be forced to amend its policy on how much hybrid debt banks can use to meet capital requirements after European regulators recommended limits.

The European Banking Authority in London is proposing that contingent convertible debt make up no more than 44 percent of the additional capital that national regulators tell the banks they oversee to hold. The so-called Pillar 2 capital is used to address risks not covered by minimum European Union requirements.

Nykredit said in May it expected its 600 million-euro ($805 million) Tier 2 CoCo to be eligible for use as both Pillar 1 and Pillar 2 capital. The lender said at the time it “may be tempted to sell more” following investor demand. The bond, which has a coupon of 4 percent, yielded 3.63 percent today in Copenhagen trading, little changed from yesterday.

Danske sold a 750 million-euro Additional Tier 1 note in March with the intention that the security could be used to meet Pillar 2 requirements, Claus Jensen, the bank’s chief investor relations officer, said by phone. The 5.75 percent note yielded 5.32 percent today, versus 5.33 percent yesterday.

In a Financial Times, piece, Alberto Gallo, head of macro-credit research at RBS, writes:

The worry is that some buyers may not understand the differences and risks of coco structures. Around a fifth of buyers are private clients, and this proportion could rise as the market goes mainstream: the first bond index for cocos was recently initiated by Bank of America Merrill Lynch.

In its last Financial Stability Report, the Bank of England mentioned the investor base for cocos had broadened, but warned that “investors were placing insufficient weight on the likelihood of a conversion being triggered”.

An analysis of existing coco bonds published by RBS shows prices only compensate for the coupon deferral risk, not for potential losses from conversion. Finally, Tobias Berg of Bonn University and Christoph Kaserer of Munich Technical University recently suggested cocos could push banks to take more risk, given their asymmetric risk-return profile with losses skewed towards investors.

No one really knows what would happen if a bank were to suspend its coupon payments, or worse, had to convert its cocos. Several investors fear this could compound volatility or even disrupt the whole market: some already predict 10 percentage point price drops the first time a bank hits a trigger on its cocos.

Regulators must act now to avoid waking up to these problems when it is too late. The first thing to do is flag clearly that cocos are not regular bonds, before investors unaware of the risks start buying. The case of Bankia’s bail-in in Spain highlighted the social pain of pushing losses on to bonds held by retail investors. Cocos can expose holders to cliff-like losses: they are not for orphans or widows.

Second, regulators need to create standards and reduce complexity across jurisdictions, clarifying how triggers and conversion mechanisms really work in a crisis. In doing so, they should favour instruments where the risks and rewards are aligned with shareholders, like cocos that convert into and dilute equity in case of losses, and discourage writedown cocos, where bondholders crystallise losses but get no upside.

All this is happening as Barclays starts marketing a CoCo index:

“CoCo issuance has steadily grown in recent years and we anticipate further expansion of this market as financial institutions issue these bonds to help achieve required regulatory capital ratios,” said Brian Upbin, Head of Benchmark Index Research at Barclays. “Though CoCos are not eligible for broad-based bond indices such as the Global Aggregate, there are debt investors who hold these securities as out-of-index investments and need a benchmark of asset class risk and returns.”

The Barclays Global Contingent Capital Index includes hybrid capital securities with explicit equity conversion or writedown loss absorption mechanisms that are based on an issuer’s regulatory capital ratio or other explicit solvency-based triggers. Subindices by currency, country, credit quality, and capital security type are available as part of this family. Bespoke credit and high-yield indices that include traditional hybrid capital as well as contingent capital securities are also now available with this expanded security coverage. The inception date of this index is May 1, 2014, and the index universe contains 65 CoCo issues with a market value of $98bn as of May 31, 2014.

Barclays also indicates:

“Though CoCos are not eligible for broad-based bond indices such as the global aggregate, there are debt investors who hold these securities as out-of-index investments and need a benchmark of asset class risk and returns,” he [Brian Upbin, head of benchmark index research at Barclays] said.

Barclays plans to exclude securities with conversion features based solely on the discretion of local regulators, those that have an additional equity conversion option based on regulatory or solvency criteria, inflation-linked bonds and floating-rate issues, private placements and retail bonds, and illiquid securities with no available internal or third-party pricing source.

Update, 2014-8-14: It has just occurred to me that this is somewhat akin to Canadian ABCP – where vendors (completely voluntarily and not with a regulatory gun to their heads at all, definitely not) compensated retail investors who lost money. At least the FCA has the decency to ban things before they go wrong … even though it means won’t get a Canadian-style slush fund out of it.

Feds Consulting on Bank Recapitalization Regime

Tuesday, August 5th, 2014

The Ministry of Finance has announced:

a public consultation on a key element of the Government’s comprehensive risk management framework for Canada’s domestic systemically important banks.

The proposed regime focuses on a specific range of liabilities and excludes deposits. In addition, insured deposits will continue to be guaranteed by the Canada Deposit Insurance Corporation.

Comments on the attached draft consultation paper can be submitted to the Department of Finance at or to the address below. The closing date for comments is September 12.

I think the first thing to observe from this announcement is that this is a deliberate slap in the face to OSFI and an indicator, yet again, of the politicization of the bank regulatory framework.

The consultation paper claims as its objective:

The Taxpayer Protection and Bank Recapitalization regime for Canada’s D-SIBs would allow for the expedient conversion of certain bank liabilities into regulatory capital when a D-SIB fails (i.e., at the point when the institution becomes non-viable). It would thus enable a resolution strategy that protects taxpayers by ensuring that losses are borne by shareholders and creditors of the failed bank while preserving the same legal entity and contracts of the bank (i.e., keeping it open or “continuing”) and, in turn, maintaining the critical services the bank provides to its customers.

… and hints at a favourable view towards a holdco/opco bank structure:

The bail-in (or equivalent) powers introduced or planned in other jurisdictions reflect the way that major banks in those jurisdictions are structured. For example, the U.S. and U.K. have large banking groups that are organized with a non-operating holding company at the top of the group, and operating bank subsidiaries underneath. In contrast, Canadian banks are organized with an operating bank as the top-tier parent company. The Government welcomes views on the potential merits of a holding company model (similar to that of other major jurisdictions) in the context of reforms to strengthen Canada’s bank resolution framework.

It is not clear whether this would or could involve a decrease in the protectionism that has given rise to the Big 6 oligopoly.

… and summarizes:

The purpose of this consultation paper is to set out the major features of a proposed Taxpayer Protection and Bank Recapitalization regime for Canada. The overarching policy objective that drives the design of the regime is to preserve financial stability while protecting taxpayers. This objective is supported by the Taxpayer Protection and Bank Recapitalization regime by:

  • ◾Reducing the likelihood of a D-SIB failure by enhancing market discipline, limiting moral hazard and constraining incentives for excessive risk-taking by ensuring that bank creditors and capital providers bear losses in the event of a D-SIB becoming non-viable;
  • ◾Ensuring that, in the event that a D-SIB experiences severe losses leading to non-viability, it can be quickly restored to viability with no or minimal taxpayer exposure to loss through a resolution strategy which enables conversion of certain liabilities into additional equity capital; and,
  • ◾Supporting D-SIBs’ ability to provide critical services to the financial system and economy during normal times and in the event that a D-SIB experiences severe losses.

First, they want statutory conversion power:

The Government proposes that the cornerstone of the Taxpayer Protection and Bank Recapitalization regime be a statutory power allowing for the permanent conversion—in whole or in part—of specified eligible liabilities into common shares of a bank (see Scope of Applicationbelow) designated as a D-SIB by OSFI,[6] following certain preconditions (see Sequencing and Preconditionsbelow). The power would also allow for (but not require) the permanent cancellation, in whole or in part, of pre-existing shares of the bank. [Footnote]

[Footnote reads]: For greater certainty, this power would only be applied to common shares of the bank which were outstanding prior to the point of non-viability

Two pre-conditions would exist before this statutory conversion:

First, there must be a determination by the Superintendent of Financial Institutions that the bank has ceased, or is about to cease, to be viable. Second, there must be a full conversion of the bank’s NVCC instruments.[8]

Note that these are necessary, but not sufficient, preconditions for the exercise of the conversion power. Authorities would retain the discretion to not exercise the conversion power even if the preconditions had been met. For example, authorities may decide not to exercise the power if conversion of NVCC instruments were deemed to be sufficient to adequately recapitalize the bank.

This would apply to new senior debt; existing senior debt will be grandfathered.

In order to allow for a smooth transition for affected market participants and to maximize legal clarity and enforceability of the Taxpayer Protection and Bank Recapitalization regime, the Government proposes that the conversion power only apply to D-SIB liabilities that are issued, originated or renegotiated after an implementation date determined by the Government. The regime would not be applied retroactively to liabilities outstanding as of the implementation date.

The Government proposes that “long-term senior debt”—senior unsecured debt[9] that is tradable and transferable with an original term to maturity of over 400 days—be subject to conversion through the exercise of the statutory conversion power.[10] Authorities would also have the ability to cancel, in whole or in part, the pre-existing common shares of the bank in the context of exercising the conversion power. This scope of application would minimize the practical and legal impediments to exercising a conversion in a timely fashion. It would also minimize any potential adverse impacts on banks’ access to liquidity under stress and support financial stability more broadly.

They would choose the proportion of senior debt converted, and there would be no ‘cram-down’ on more junior instruments other than common shares:

The Government proposes that authorities have the flexibility to determine, at the time of resolution, the portion of eligible liabilities that is to be converted into common shares in accordance with the conversion power. All long-term senior debt holders would be converted on a pro rata basis—that is, each of these creditors would have the same portion (up to 100 per cent) of the par value of their claims converted to common shares.

Authorities’ determination of the total amount of eligible liabilities to be converted would be based on ensuring that the D-SIB emerges from a conversion well-capitalized, with a buffer of capital above the target capital requirements set by OSFI.

Conversion of eligible liabilities would respect the hierarchy of claims in liquidation on a relative, not absolute, basis. For example, for every dollar of their claim that is converted, long-term senior debt holders would receive economic entitlements (in the form of common shares) that are more favourable than those provided to former NVCC subordinated debt investors, but NVCC subordinated debt investors would not be subject to 100 per cent losses in the context of exercising the conversion power.

Conversion terms would be similar in form to NVCC conversion:

Building on this approach, and to provide greater certainty and transparency to investors and creditors that may be subject to the statutory conversion power, the Government proposes to link the conversion terms it would apply with respect to eligible liabilities to those of outstanding NVCC instruments. Specifically, the number of common shares that would be provided for each dollar of par value of a claim that is converted would be tied to the conversion formulas of any outstanding NVCC instruments.

This approach would be communicated to all market participants in advance, and would be applied as follows: long-term senior debt holders would receive, for each dollar of par value converted, an amount of common shares determined as a fixed multiple, X,of the most favourable conversion formula[12] among the bank’s NVCC subordinated debt instruments (or, if none exists, the bank’s NVCC preferred shares[13]).[14]

As with the overall approach, the fixed conversion multiplier, X, would be set in advance by public authorities through regulation or guidance (and would thus be public information).[Footnote]

[Footnote reads:] For example, a potential range for the conversion multiplier would be 1.1 to 2.0.

As discussed in the post Royal Bank Issues NVCC-Compliant Sub-Debt, the conversion multiplier is essentially affects the floor conversion price of the common (which may be assumed to be very low in a non-viability situation); $5 for preferred shares, For sub-debt, the formula is:

The “Contingent Conversion Formula” is (Multiplier x Note Value) ÷ Conversion Price = number of Common Shares into which each Note shall be converted.

The “Multiplier” is 1.5.

The “Note Value” of a Note is the Par Value plus accrued and unpaid interest on such Note.

The “Conversion Price” of each Note is the greater of (i) a floor price of $5, and (ii) the Current Market Price of the Common Shares.

If they want to keep the senior debt senior to the sub-debt, the conversion multiplier may have to be more than 1.5! However, they’re also giving themselves the ability to cancel existing common, so it doesn’t really matter what the multiplier is.

In a startling nod to the rule of law, there is actually an intention to allow access to the courts to complain!

The Government proposes that shareholders and creditors subject to conversion be entitled to be made no worse off than they would have been if the bank had been resolved through liquidation. The Government further proposes that the process for determining and, if necessary, providing compensation to shareholders and creditors that have been subject to conversion build on existing processes set out in subsections 39.23 to 39.37 of the Canada Deposit Insurance Corporation Act.

The Canada Deposit Insurance Corporation Act contains the usual bafflegab, but essentially allows dissenting bond-holders to take their case for additional compensation to court.

There will be a minimum amount of convertible instruments:

The Government therefore proposes that D-SIBs be subject to a Higher Loss Absorbency (HLA) requirement to be met flexibly through the sum of regulatory capital (i.e., common equity and NVCC instruments) and long-term senior debt (see Scope of Applicationabove) that is directly issued by the parent bank.

The Government proposes that the HLA requirement be set at a specific value (as opposed to a range). The Government further proposes that this value be between 17 and 23 per cent of risk-weighted assets (RWA). For example, a HLA requirement at the low end of this range (17 per cent of RWA) would ensure that banks could absorb losses of 5.5 per cent of RWA and emerge from a conversion with common equity of 11.5 per cent of RWA (Basel III minimum Total Capital Ratio of 10.5 per cent plus a buffer of 1 per cent).

They state an intention to fiddle with deposit insurance:

The Government is committed to ensuring that Canada’s deposit insurance framework adequately protects the savings of Canadian consumers. In this regard, deposits will be excluded from the Taxpayer Protection and Bank Recapitalization regime. As announced in Economic Action Plan 2014, the Government plans to undertake a broad review of Canada’s deposit insurance framework by examining the appropriate level, nature, and pricing of protection provided to deposits and depositors.

This is very mysterious, but I assume that uninsured deposits – and deposit notes! – will be senior to senior debt. I just hope to bloody hell they resolve the BA vs. BDN mystery.

Finally, they list the specific questions they want to pretend to address:

Questions for Consultation

1.Is the proposed scope of securities and liabilities that would be subject to the conversion power appropriate? Why / why not?

2.Is the proposed minimum term to maturity at issuance of 400 days appropriate for the purpose of differentiating between short-term and long-term liabilities?

3.Does the proposed regime strike the correct balance between flexibility for authorities and clarity and transparency for market participants?

4.Is the proposal for a fixed conversion multiplier appropriate? Why / why not? What considerations should be taken into account when setting the value of a fixed conversion multiplier as proposed?

5.Is the proposed form of the Higher Loss Absorbency requirement appropriate? What considerations should be taken into account when setting this requirement?

6.Should authorities have the flexibility to provide compensation to written-down creditors in the form of preferred shares in the bank (i.e., instead of common shares)? Why / why not?

7.What would be an appropriate transition period for implementation of the Taxpayer Protection and Bank Recapitalization regime?

8.Are the proposed objectives for the review of existing resolution powers and incorporation of the conversion power into Canada’s bank resolution framework appropriate? What additional considerations should be taken into account to maximize the effectiveness of the conversion power as part of the overall resolution framework?

9.Could a holding company model provide advantages in the application of the bridge bank powers (i.e., akin to the U.S. approach) or conversion powers (i.e., akin to the U.K. approach)?

As usual, there are two fundamental objections to the proposed scheme: firstly, these are all low-trigger conversions, which might be good enough to resolve a crisis, but do not even attempt to avert a crisis; secondly, it gives powers formerly held by a bankruptcy court to a handful of highly politicized, unscrutinized bureaucrats in the CDIC.

I see the whole thing as a lot of flim-flam; a fig-leaf over the ravaging of the rule of law. In any future horrific scenario, there will be so much uncertainty regarding the fate of capital instruments that a bank in dire straits simply will not be able to issue anything.