Feds Consulting on Bank Recapitalization Regime

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 ConsultationsFSS-SSF@fin.gc.ca 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.

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