It was announced in the 2013 Budget that a bail-in regime will be introduced for Canada’s systemically important banks. The Budget stated that the bail-in regime “…will be designed to ensure that, in the unlikely event that a systemically important bank depletes its capital, the bank can be recapitalized and returned to viability through the very rapid conversion of certain bank liabilities into regulatory capital. This will reduce risks for taxpayers.”
This announcement caused a commotion and resulted in concerns about “Cyprus-style” bail-ins that would target Canadians' deposits.In response, Kathleen Perchaluk, Press Secretary of the Office of the Minister of Finance, clarified that “The bail-in scenario described in the budget has nothing to do with depositors’ accounts and they will in no way be used here.”
While the Government’s clarification may have allayed some concerns, significant uncertainty remains regarding how a Canadian bail-in regime will work. In light of this, this Bulletin provides an overview of bail-in and some of the key issues relating to a Canadian bail-in regime, including the relationship between bail-in and Non-Viability Contingent Capital (NVCC).
Bail-in is a Response to the Financial Crisis and the Too-Big-to-Fail Problem
During the global financial crisis some financial institutions (none of which, it should be noted, were Canadian) were considered “too-big-to-fail” and were bailed-out by large scale government support. There was widespread concern about taxpayers funding the rescue of these institutions and the resulting moral hazard. It has been observed that government intervention to prop up a failing company can foster moral hazard by incentivizing companies to take more risks and investors to act less diligently or cautiously.
Bail-in is intended to at least partially answer these concerns. Bail-in involves restructuring the liabilities of a distressed financial institution by writing down debt and/or converting it to equity.In effect, bail-in creates equity by reducing liabilities.
Bail-in became a high profile topic earlier this year as a result of the events in Cyprus. In response to the 2012-2013 Cypriot financial crisis, it was initially announced that there would be a 6.75% levy on insured deposits (i.e., deposits of up to €100,000) and a 9.9% levy on deposits in excess of the insurance limit. Depositors were to be compensated with shares in the bank. This deal was rejected by the Cypriot parliament. The final rescue deal, which involved €10B for Cyprus, was announced in March 2013 and involved bailing-in creditors (bondholders and uninsured depositors), but not insured deposits.
The starting point for anticipating what Canada’s bail-in regime will look like is the Financial Stability Board (FSB) Key Attributes of Effective Resolution Regimes for Financial Institutions (the “Key Attributes”), which were endorsed by the G20 in November 2011. The Key Attributes provide for “bail-in within resolution” that enables a designated administrative authority or authorities (referred to a “resolution authority”) to:
- write down in a manner that respects the hierarchy of claims in liquidation (see Key Attribute 5.1) equity or other instruments of ownership of the firm, unsecured and uninsured creditor claims to the extent necessary to absorb the losses; and to
- convert into equity or other instruments of ownership of the firm under resolution (or any successor in resolution or the parent company within the same jurisdiction), all or parts of unsecured and uninsured creditor claims in a manner that respects the hierarchy of claims in liquidation;
- upon entry into resolution, convert or write-down any contingent convertible or contractual bail-in instruments whose terms had not been triggered prior to entry into resolution and treat the resulting instruments in line with (i) or (ii).
The Key Attributes state that it should be possible to apply bail-in in conjunction with other resolution powers (e.g., removal of problem assets, replacement of senior management and adoption of a new business plan).The idea is that in addition to recapitalizing a bank through bailing-in certain liabilities, the root causes of the problems should also be addressed.
Key Issues in Bail-In
What Debt is Subject to Being Bailed-In?
The Key Attributes refer to the bail-in of “unsecured and uninsured creditor claims”. Accordingly, presumably secured debt and insured deposits will not be subject to the bail-in regime. As noted in the Final Report - Recommendations of the U.K. Independent Commission on Banking, there are also issue issues with bailing-in derivatives counterparties and central counterparties and bailing-in short-term unsecured debt and uninsured deposits.
In considering possible exclusions from the scope of bail-in, it is worth reviewing the approach taken in the Council of the European Union’s directive establishing a framework for the recovery and resolution of credit institutions and investment firms (which the European Parliment and EU Member States agreed upon on December 12, 2013). The directive provides that the following types of liabilities would be permanently excluded from bail-in:
- insured deposits;
- secured liabilities including covered bonds;
- liabilities to employees of failing institutions;
- commercial claims relating to goods and services critical for the daily functioning of the institution;
- liabilities arising from a participation in payment systems which have a remaining maturity of less than seven days; and
- inter-bank liabilities with an original maturity of less than seven days.
The directive provides that national resolution authorities would also have the power to exclude, or partially exclude, liabilities on a discretionary basis for specified reasons (i.e., to ensure continuity of critical functions and to avoid contagion).
A key issue with bail-in is the extent to which it is consistent with, or deviates from, the normal hierarchy of claims in liquidation. In this regard, the Key Attributes contain the following statement:
Resolution powers should be exercised in a way that respects the hierarchy of claims while providing flexibility to depart from the general principle of equal (paripassu) treatment of creditors of the same class, with transparency about the reasons for such departures, if necessary to contain the potential systemic impact of a firm’s failure or to maximise the value for the benefit of all creditors as a whole. In particular, equity should absorb losses first, and no loss should be imposed on senior debt holders until subordinated debt (including all regulatory capital instruments) has been written-off entirely (whether or not that loss-absorption through write-down is accompanied by conversion to equity).
In a winding-up and liquidation of a bank pursuant to the Winding-up and Restructuring Act, holders of shares and subordinated debt would not recover anything unless senior creditors were paid in full. An “absolute priority” approach to bail-in implies that senior debt should not be converted to common shares until all junior ranking claims (i.e., shares and subordinated debt) have been written off.
A “relative priority” approach to bail-in would not require shares and subordinated debt to be written off before senior debt was converted to common shares. This is the approach taken by the NVCC requirement, which involves the dilution - not the wiping out - of pre-existing common shareholders.
The concern with a relative priority approach is that if shareholders and holders of subordinated debt own common shares after bail-in is triggered, they have an asset with some value, no matter how diluted they may be as a result of the conversion of senior debt. This is inconsistent with existing Canadian insolvency law and arguably represents a transfer of value from senior creditors to those with junior ranking claims.
One possible response to this is that the bail-in regime will likely include a mechanism to ensure senior creditors are compensated if they are worse off as a result of being bailed-in than they would have been in a liquidation scenario. The Key Attributes provide that “Creditors should have a right to compensation where they do not receive at a minimum what they would have received in a liquidation of the firm under the applicable insolvency regime...”
Bail-in is intertwined with NVCC both in theory and, quite possibly, in practice.
As background, under OSFI’s Capital Adequacy Requirements Guideline, non-common Tier 1 and Tier 2 capital instruments must satisfy the NVCC requirement, meaning they must have a contractual clause requiring a full and permanent conversion into common shares upon a trigger event. There are two mandatory trigger events:
- the Superintendent of Financial Institutions announces that the institution has been advised, in writing, that the Superintendent is of the opinion that the institution has ceased, or is about to cease, to be viable and that, after the conversion of all contingent instruments and taking into account any other relevant or appropriate factors or circumstances, it is reasonably likely that viability will be restored or maintained; and
- a federal or provincial government publicly announces that the institution has accepted or agreed to accept a capital injection, or equivalent support, without which the institution would have been determined by the Superintendent to be non-viable.
The Capital Adequacy Requirements Guideline provides that the conversion method is to take into account the hierarchy of claims in liquidation and result in the significant dilution of pre-existing common shareholders.
Bail-in and NVCC Serve the Same Purposes
The basic rationale for bail-in and NVCC is the same. As noted in the paper Contingent Capital and Bail-In Debt: Tools for Bank Resolution, gone-concern contingent capital (such as NVCC) and bail-in debt share two related objectives: (1) to support the resolution of a failing bank by providing sources of capital when the institution cannot recapitalize through private markets; and (2) to ensure that equity holders and other providers of regulatory capital, as well as major creditors of banks, face risk of loss, even if the troubled bank is not closed and liquidated.
The authors of that paper note that contingent capital and bail-in instruments could improve the incentives affecting private behaviour by exposing common shareholders to the risk of significant dilution and by widening the pool of market participants with credible “skin in the game”, which could improve market discipline and reduce moral hazard.
As noted above, NVCC instruments are required to set out the basis for conversion to common shares (i.e., the conversion formula) in the relevant instrument. It has not been made clear whether Canada’s bail-in regime will provide for bail-in on a statutory basis or a contractual basis. It has also not been made clear whether the basis for conversion to common shares will be specified in advance or determined at the time of the bail-in.
This results in significant uncertainty because it is entirely possible that in circumstances in which NVCC could be triggered, bail-in would also be triggered. Where a bank has ceased or is about to cease to be viable (which, as noted above, is one of the mandatory triggers for NVCC), it is quite possible that the conversion of NVCC instruments will not absorb sufficient losses to restore the bank to viability. In that case, additional liabilities may be converted to common shares via bail-in.
The fact that NVCC and bail-in may both be triggered at or around the same time gives rise to two questions:
- If NVCC instruments were converted to common shares on the basis of the NVCC conversion formula specified in the relevant instrument and senior debt was bailed-in and converted to common shares on some other basis, how many common shares would holders of converted NVCC instruments receive in relation to how many common shares bailed-in senior creditors would receive?
- Would NVCC instruments be converted to common shares based on the NVCC conversion formula specified in the relevant instrument or would such instruments be bailed-in and converted to common shares on some other basis? As noted above, the Key Attributes provide that bail-in should include the ability to convert or write-down any contingent convertible or contractual bail-in instruments whose terms had not been previously triggered, which implies that subordinated debt with NVCC terms would be subject to bail-in.
Both questions would be relevant to investors trying to assess the risks associated with investing in NVCC instruments or bail-inable debt, and at this point the answers are not clear. It is possible that uncertainty regarding the bail-in regime and how it will interact with NVCC is one of the reasons a market for NVCC instruments has not developed in Canada.
Other Issues and Questions
There are a number of other significant issues and questions relating to bail-in, including the following:
- What will be the trigger for the conversion of bail-inable debt and how will this compare to the trigger for the conversion of NVCC instruments?
- How will bail-in impact the cost of funding for Canada’s D-SIBs? Since bail-in is designed to transfer risk from taxpayers to creditors, presumably the affected creditors will demand some compensation for this.
- There are limitations on the ability of some investors in bank debt to own common shares in banks. The introduction of a bail-in regime may therefore present issues for these investors.
- Will the bail-in regime purport to apply to outstanding debtor will it only apply to debt issued after the introduction of the regime?
- If the bail-in power is provided for in legislation there may be challenges enforcing the exercise of this power in non-Canadian courts. This issue would likely be addressed to the extent investors agreed to be bailed-in (e.g., if it was a term of the relevant contract or instrument).
- Will there be a minimum required amount of bail-inable debt? It has been noted that a minimum amount of bail-inable debt would help reassure the market that a bail-in would be sufficient to recapitalize the distressed institution, thus forestalling potential runs by short-term creditors and averting a downward share price spiral.
There is significant uncertainty regarding how a Canadian bail-in regime will be structured, how it will impact the existing creditor hierarchy and how it will interact with NVCC. It will be interesting to see what the Government proposes and what the reaction is. There are a variety of stakeholders, including Canada’s D-SIBs, equity and debt investors, retail depositors, and the public, each with their own interests and perspectives. Accordingly, a uniform response should not be expected.
Finally, it is important to recognize that only some of the questions relating to bail-in will be answered by the choices the Government makes in designing a bail-in regime. Other questions, such as the impact on cost of funding, will be answered by the market and others might only be answered if bail-in ever proves necessary.