Preferreds & Tier 1 Capital (Part I)

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

Tier One Capital of Two Banks
Total Tier 1 Capital (millions) 11,935 16,641
Common Shareholders’ Equity 83.2% 86.9%
Preferred Shares 25.0% 6.3%
Innovative Tier 1 Capital Instruments 0.0% 13.2%
Non-controlling interests in subsidiaries 0.0% 0.0%
Goodwill -8.2% -6.6%

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

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

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

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

Preferred Shares (Tier 1)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

One Response to “Preferreds & Tier 1 Capital (Part I)”

  1. […] Those who are familiar with the rules for Tier 1 bank capital will be most amused by the following bizarre attempt to create a controversy (hat tip: Financial Webring Forum): When either Freddie or Fannie attempt to build capital, they are handicapped by a peculiarity that very few investors know about: They cannot sell the most popular kind of preferred stock, the “cumulative” variety, because their regulator will not let these securities count toward capital. […]

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