Last month, Canada’s Department of Finance published a consultation paper outlining a proposed taxpayer protection and bank recapitalization (bail-in) regime. The implementation of such a regime is intended to avoid the “unacceptable costs to the economy” that would result were a domestic systematically important bank to fail. The proposed regime is thus intended to reduce the likelihood of failure and, in the unlikely event of such failure, ensure the restoration of a bank’s viability with minimal taxpayer exposure to loss.
Below are some of my thoughts on the proposal.
- It is interesting that the bail-in project is being led by the Department of Finance rather than the Office of the Superintendent of Financial Institutions. OSFI’s Assistant Superintendent, Mark Zelmer offered this partial explanation last year:
Closely related to NVCC is the issue of bail-in debt instruments. These will be debt instruments issued by D-SIBs, where holders of such instruments could also find their claims converted into regulatory capital, in the event the bank needs to be recapitalized. Given this is not a bank capital issue, the design of the bail-in debt framework is being led by the Department of Finance.
Having said that, the consultation paper proposes 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 subject to the bail-in regime. In everything but name, this is simply a higher capital requirement that can be met in part through bail-in capital. It is possible that the political sensitivity around exposing depositors’ money to risk of loss has led to Finance’s leading role.
- The government proposes that “long-term senior debt”, defined as senior unsecured debt that is tradable and transferable with an original term to maturity of over 400 days, be subject to the bail-in regime. In my view, the better approach would be to simply require that banks issue enough debt subject to the bail-in regime to meet, in combination with traditional regulatory capital, the HLA requirement.
I think that there are a number of problems with the suggested approach. First, it discourages the issuance of debt with maturities beyond 400 days, in favour of less stable funding sources. Second, preserving the ability of a bank to issue non-bail-in senior debt with a term of 400 days or more (provided that the HLA requirement is otherwise met) could allow the banks to recoup any spread incurred on bail-in debt. Third, allowing the continued issuance of non-bail-in debt could provide useful liquidity in circumstances of stress. Fourth, the spread between bail-in and non-bail-in debt could promote market discipline, which is the third pillar of Basel lll. Finally, requiring all long-term senior debt to be bail-in debt is not consistent with the statement that the HLA requirement can be met flexibly through a combination of bail-in debt and regulatory capital.
- The bail-in capital power is exercisable only upon a determination by the Superintendent of Financial Institutions that the bank has ceased, or is about to cease, to be viable, and after a full conversion of the bank’s NVCC instruments. This “late trigger” represents a significant change from OSFI’s original conception of bail-in capital as a measure that would avoid the need for government intervention. Instead, it is now, like NVCC, a tool exercisable only upon or on the eve of intervention. This may be contrasted with the approach taken in Barclays Coco issuance in which the trigger for conversion is defined as a "Capital Adequacy Trigger Event", which occurs if the CET1 Ratio as of any relevant date is less than seven per cent. The advantage of the concurrent conversion is that it does tend to make simpler the preservation of the relative priority of the senior debt. In the Barclays issuance, that was not an issue because the debt in the Barclays transaction would be cancelled rather than converted.
- The consultation paper provides that the authorities would have the flexibility to determine, at the time of resolution, the portion of eligible liabilities that was 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. What the consultation paper does not say is whether the conversion power would be exercised only if the bank could thereby be restored to solvency and ordinary course operation, or whether the conversion power could also be exercised even if the ultimate plan was to liquidate all or part of the bank.
- An additional term of the conversion is that conversion of eligible liabilities would be subject to the principle that no creditor be worse off as a result of conversion than they would have been in a traditional liquidation. It is hard to see how this could be given effect in practice since the facts required to make that determination would likely be either unavailable or open to dispute. Given the timing considerations, it is hardly likely that a creditor would be given the right to challenge the conversion on this basis. In practice, it is likely to be a matter that is required to be addressed by the authority vested with the conversion authority, but in the context of a non-reviewable discretion. However, the consultation paper does provide for after-the-event compensation:
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.
It is not clear how such a regime can or should work in circumstances where the financial institution has not been liquidated given that the former holders now hold common shares and were intended by reason of the conversion to take a “haircut”. The payment of compensation by CDIC would defeat the purpose of the exercise, which would be to avoid the commitment of government funds, and the payment of compensation by the restructured bank, which could create an unintended and unacceptable overhang.
- The consultation paper contemplates a fixed conversion ratio under which 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 among the bank’s NVCC subordinated debt instruments (or, if none exists, the bank’s NVCC preferred shares. The consultation paper also contemplates that the conversion power would allow for (but not require) the permanent cancellation, in whole or in part, of pre-existing shares of the bank. Presumably, the reference to the pre-existing shares of the bank is not intended to capture shares issued as part of an NVCC conversion. Presumably this would have its primary expression in the application of the floor price for conversion, and would reflect the existing distinction drawn between the NVCC Conversion of preferred shares and the NVCC conversion of subordinated debt.
The consultation paper acknowledges that the result is a recognition of “relative” priority rather than “absolute “ priority, that is that senior debt holders are entitled to more favourable conversion terms (at least in the vicinity of the floor price) than subordinated debt holders and preferred shareholders, just as the existing RBC subordinated debt deal offers better conversion terms in the vicinity of the floor price to subordinated debt holders over preferred shareholders. Interestingly if the power to cancel “pre-exisiting common shares” is exercised, the benefit of that cancellation would be shared between the holders of NVCC converted common shares and bail-in converted common shares.
- It is not clear where the conversion authority would be vested. The consultation paper makes reference to the “authorities” without specifying exactly what is intended by that term, although the CDIC is referred to as a “resolution authority”.
- The consultation paper contemplates that conversion would be effected by means of a statutory power allowing for the permanent conversion—in whole or in part—of specified eligible liabilities into common shares of a bank. There may be issues relative to whether a purely statutory conversion power would be effective as regards debt instruments governed by foreign law or debt instruments held by foreign holders. In the Barclays Coco issuance this statutory power is supplemented by a contractual provision:
By its acquisition of the Notes, each holder shall (i) agree to all the terms and conditions of the Notes, including, without limitation, those related to the occurrence of a Capital Adequacy Trigger Event and any related Automatic Write-Down, (ii) agree that effective upon, and following, the occurrence of the Automatic Write-Down, other than with respect to payments that have become due and payable prior to such Automatic Write-Down, no amount shall be due and payable to the holders under the Notes, and the holders shall not have the right to give a direction to the trustee with respect to the Capital Adequacy Trigger Event and any related Automatic Write-Down and (iii) waive, to the extent permitted by the Trust Indenture Act, any claim against the trustee arising out of its acceptance of its trusteeship for the Notes, including, without limitation, claims related to or arising out of or in connection with a Capital Adequacy Trigger Event and/or the Automatic Write-Down.
The consultation paper addresses this issue in a similar manner:
In order to promote transparency for investors and creditors that may be subject to conversion, the Government proposes that all D-SIBs be required to … include a clause in the contractual provisions governing any eligible liability through which investors provide express submission to the Canadian Taxpayer Protection and Bank Recapitalization regime, notwithstanding any provision of foreign law to the contrary.
The consultation paper also provides for disclosure to investors:
In order to promote transparency for investors and creditors that may be subject to conversion, the Government proposes that all D-SIBs be required to include specific disclosures related to the conversion power in any agreement governing an eligible liability as well as any accompanying offering documents.
The bail-in regime is likely to have other effects on the offering and disclosure regime applicable to debt of a bank.
Whether the proposal is enacted as proposed, however, remains to be seen. The Department of Finance is accepting comments, including in respect of specific consultation questions, until September 12.