On December 16, 2010, the Basel Committee on Banking Supervision (BCBS) released new international bank capital adequacy rules and rules for minimum and appropriate forms of bank liquidity (commonly called Basel III). On January 13, 2011, the BCBS released additional Basel III requirements that relate to loss absorbency of capital instruments. The Office of the Superintendent of Financial Institutions of Canada (OSFI) has recently provided some guidance in its advisories (full text available here) on how it plans to implement certain of the Basel III requirements as they apply to banks and federally regulated trust and loan companies (collectively referred to as deposit-taking institutions or DTIs).

Revising OSFI Guidelines

  • To implement the Basel III bank capital rules, OSFI plans to revise its capital adequacy guidelines (the new guidelines are expected to be in place before the end of calendar 2012, for implementation in the first fiscal quarter in 2013).
  • Subject to the completion by BCBS of outstanding items related to the Basel III capital rules, OSFI expects to commence consultation on the revisions to its capital adequacy guidelines during 2011. OSFI expects its minimum requirements to follow the Basel III transition plan and DTIs are expected to have in place and pursue internal capital plans and targets that will enable them to meet the Basel III capital requirements. In view of the new international rules for minimum and appropriate forms of bank liquidity, OSFI will amend its relevant guidelines in time for implementation at the beginning of 2015 (the Liquidity Coverage Ratio) and 2018 (the Net Stable Funding Ratio). OSFI intends to commence public consultation during 2011 on revised liquidity rules.

Phase-Out of Non-Qualifying Capital

  • Capital instruments issued prior to September 12, 2010 that previously qualified as regulatory capital but do not meet Basel III criteria will be phased out beginning January 31, 2013 (their recognition will be capped at 90% from January 1, 2013, with the cap reducing by 10% in each subsequent year).
  • Capital instruments issued before January 1, 2013 that meet the Basel III criteria for regulatory capital (other than the NVCC requirements (discussed below)), will also be subject to the phase-out described above.
  • Capital instruments issued between September 12, 2010 and January 1, 2013 that do not meet the Basel III criteria (other than the NVCC requirements) will be excluded from regulatory capital as of January 1, 2013.
  • DTIs should prioritize redeeming capital in a way that will give effect to the following priorities: (i) maximize the amount of non-qualifying capital instruments outstanding during the Basel III transition period (based on the assumption that all such capital will be redeemed at the earliest regular redemption date at par) and (ii) minimize the amount of capital that would be subject to redemption because of reliance on a “regulatory event” redemption feature in the applicable capital instruments.
  • If a DTI expects to use a regulatory event redemption, it should develop (and disclose to the public as soon as practicable) a regulatory event redemption schedule that specifies the expected redemption date for each non-qualifying instrument. If a DTI expects that it will not redeem any capital instruments through the use of a regulatory event redemption, it should also disclose this to the public.

Non-Viability Contingent Capital

OSFI has released a draft advisory outlining its expectations in respect of issuance of non-viability contingent capital (NVCC) by DTIs. Some highlights of this advisory are noted below:

  • Effective January 1, 2013, all non-common Tier 1 and Tier 2 capital instruments issued by DTIs must have, in their contractual terms and conditions, a clause requiring a full and permanent conversion into common shares of the DTI upon a trigger event. The trigger events would be that (a) the Superintendent of Financial Institutions (the “Superintendent”) advises the DTI, in writing, that she is of the opinion that the DTI has ceased, or is about to cease, to be viable and that, after the conversion of all contingent capital instruments and taking into account any other factors or circumstances that she considers relevant or appropriate, it is reasonably likely that the viability of the DTI will be restored or maintained; or (b) a federal or provincial government in Canada publicly announces that the DTI has accepted or agreed to accept a capital injection, or equivalent support, from the federal government or any provincial government or political subdivision or agent or agency thereof without which the DTI would have been determined by the Superintendent to be non-viable.
  • All NVCC instruments must also meet all other criteria for inclusion under their respective tiers as specified in Basel III. The holders of NVCC instruments, after such conversion, must not have any residual claims that are senior to common equity following a trigger event.
  • The conversion methodology applicable to NVCC instruments should reflect the hierarchy of claims in liquidation, should consider the market value of common equity and may also consider the market value of other instruments in the capital structure. More specifically, the conversion should demonstrate that former subordinated debt holders receive economic entitlements which are more favourable than those provided to former preferred shareholders, and that former preferred shareholders receive economic entitlements which are more favourable than those provided to pre-existing common shareholders.
  • The issuing DTI must ensure there are no impediments to the conversion so that conversion will be automatic and immediate (e.g., no impediments in the DTI’s by-laws or other constating documents or no other authorizations would be required).
  • The terms and conditions of the NVCC must specify that conversion does not constitute an event of default under that instrument. Further, the issuing DTI must take all commercially reasonable efforts to ensure that conversion is not an event of default or credit event under any other agreement entered into by the DTI, directly or indirectly, on or after the date of the advisory relating to NVCC was first issued for public consultation (i.e., February 4, 2011), including senior debt agreements and derivative contracts.
  • The issuing DTI must provide a trust arrangement or other mechanism to hold shares issued upon the conversion for non-common capital providers that are not permitted to own common shares of the DTI due to legal prohibitions.
  • In assessing whether a DTI has ceased, or is about to cease, to be viable and that, after the conversion of all NVCC instruments, it is reasonably likely that the viability of the DTI will be restored or maintained, OSFI has indicated that the Superintendent would consider a number of relevant factors, some of which may include: (i) whether the assets of the DTI are sufficient to provide adequate protection to the DTI’s depositors and creditors, (ii) whether the DTI has lost the confidence of depositors or other creditors and the public, (iii) whether the DTI’s regulatory capital has, in the opinion of the Superintendent, reached a level, or is eroding in a manner, that may detrimentally affect its depositors and creditors, (iv) has the DTI failed to pay any liability that has become due and payable or will the DTI not be able to pay its liabilities as they become due and payable, (v) has the DTI failed to comply with an order of the Superintendent under paragraph 485(3)(a) of the Bank Act to increase its capital, (vi) any other state of affairs exists in respect of the DTI that may be materially prejudicial to the interests of the DTI’s depositors or creditors or the owners of any assets under the DTI’s administration, including where proceedings under a law relating to bankruptcy or insolvency have been commenced in Canada or elsewhere in respect of the holding body corporate of the bank, and (vii) is the DTI unable to recapitalize on its own through the issuance of common shares or other forms of regulatory capital.
  • The Superintendent has the discretion not to trigger NVCC notwithstanding that a DTI has ceased, or is about to cease, to be viable. Under such circumstances, the DTI’s creditors and shareholders could be exposed to losses through the continued operation of the DTI and through the use of liquidation or other resolution tools.