OSFI Debases Bank Capital Quality

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.

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

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.

11 Responses to “OSFI Debases Bank Capital Quality”

  1. prefhound says:

    OSFI action reminds me of how Aeroplan deflated Aeroplan points by requiring 40% more to take a trip (not to mention making them expire rapidly). I presume they only acted because the banks asked them to.

    We don’t need Canadian bank prefs to be more equity-like. We already have a situation where the prefs of many (except CIBC) are down more than the common, in percentage terms.

    Surely if the banks can issue $200M prefs at a time in fixed resets and sell to an eager retail clientele, they could sell $1B common stock. With the OSFI changes, we pref owners will be more at downside risk — with less upside than the increasingly leveraged common shares. I thought leverage was a bad word these days, but for pref owners, 25X assets/common equity is a LOT of leverage.

    For pref owners, Canadian banks seem to be steadily INCREASING leverage to deal with the credit crisis, increasing the risks if/as/when something blows up in Canada.

    Taken to an extreme, this shows some of the same issues as BCE debt: stranded in junk land when the company chooses to recapitalize and blow the credit rating.

  2. prefhound says:

    Unfortunately, for pref holders to go “on strike” and not buy new issues, the price of existing issues would have to fall even further…..

  3. […] OSFI has debased bank capital quality (at least we now know where the instruction came from – I thought it was National Bank, who have basically maxed out their issuance capacity under the old rules) […]

  4. […] 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 […]

  5. […] preferred shares & Innovative instruments. Item B is as per OSFI Guidelines; the limit was recently increased.Items D & F are my […]

  6. […] 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 […]

  7. […] 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 […]

  8. […] except preferred shares and innovative instruments Item B is as per OSFI Guidelines; the limit was recently increased. Note, however, that my calculations are based on ‘Adjusted net Tier 1 capital’, while […]

  9. […] Julia Dickson of OFSI made some remarks to the Commons Finance Committee, but there was nothing startling there. She emphasized the importance of having high quality capital in the banks (lots of common!) but neglected to highlight OSFI’s recent debasement of capital quality. […]

  10. […] can hope that OSFI signs on to the bit about increasing bank capital quality! The important issue being discussed is the “build up of capital buffers” – one of the […]

  11. […] on the composition of Tier 1 Capital interesting, particularly given the Canadian limits following OSFI’s debasement of bank capital: Ahead of the crisis, the composition of banks’ capital shifted away from common equity and […]

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