On June 16, 2017, the Department of Finance pre-published three new regulations critical to the implementation of Canada's bail-in regime, and the Office of the Superintendent of Financial Institutions ("OSFI") released draft guidance regarding total loss absorbing capacity ("TLAC") requirements. Comments on the proposed regulations and the draft TLAC Guideline are to be submitted by July 17, 2017.

The following regulations have been proposed (collectively, the "Regulations"):

  1. Bank Recapitalization (Bail-in) Conversion Regulations - this regulation would be made pursuant to the Canada Deposit Insurance Corporation Act ("CDIC Act") and would set out the scope of liabilities eligible to be bailed-in.
  2. Bank Recapitalization (Bail-in) Issuance Regulations - this regulation would be made pursuant to the Bank Act and would set out requirements relating to the issuance of bail-in eligible securities.
  3. Compensation Regulations - this regulation would be made pursuant to the CDIC Act and would set out an updated process for providing compensation to shareholders and creditors of a federal Canada Deposit Insurance Corporation ("CDIC") member institution that are made worse off as a result of the resolution actions than they would have been if the institution had been liquidated.

It is expected that final versions of the Regulations will be published in the fall of 2017. While the effective date of the TLAC Guideline is still to be determined, it is OSFI's expectation that domestic systemically important banks ("D-SIBs") will meet their minimum TLAC requirements on or before November 1, 2021.

Background

Following the 2008 financial crisis, a number of reforms to Canada's regulatory regime were made to address concerns about banks that are "too big to fail" - particularly, the risk that taxpayers will bear the cost of "bailing-out" such banks if they become non-viable.

Legislation introducing the bail-in regime received Royal Assent last year (please refer to our earlier Bulletin). Canada's bail-in regime is designed to allow authorities to quickly convert certain debt of a D-SIB into common shares to recapitalize the bank and help restore it to viability. Use of the bail-in conversion tool would require a determination by the Superintendent of Financial Institutions (Canada) ("Superintendent") that the bank has ceased, or is about to cease, to be viable, and Governor in Council approval, on the recommendation of the Minister of Finance, for CDIC to take temporary control or ownership of the non-viable bank and carry out a bail-in conversion. After the bail-in conversion and any other necessary restructuring steps had been completed, the bank would be returned to private control. Following the resolution, CDIC would make an offer of compensation to the relevant shareholders and creditors if they were worse off than they would have been in liquidation. There is a process to have this offer reviewed by a third party assessor.

Another component of the bail-in regime is the requirement that D-SIBs maintain sufficient TLAC. This requirement is intended to ensure that D-SIBs have sufficient equity and loss-absorbing liabilities to withstand severe, but plausible, losses and be restored to viability. These requirements are set by the Superintendent.

Canada's bail-in regime is consistent with international standards developed by the Financial Stability Board and endorsed by the G20.

Draft Regulations

The key features of each of the Regulations is summarized below:

Bank Recapitalization (Bail-in) Conversion Regulations

This regulation specifies that liabilities that are eligible for bail-in conversion are debt obligations, other than subordinated indebtedness, issued by a D-SIB and meeting the following criteria:

  • is perpetual, has an original or amended term to maturity of more than 400 days, has one or more explicit or embedded options that, if exercised by or on behalf of the issuer, could result in a maturity date that is more than 400 days from the date of issuance or has an explicit or embedded option that, if exercised by or on behalf of the holder, could by itself result in a maturity date that is more than 400 days from the maturity date that would apply if the option were not exercised;
  • is unsecured or is only partially secured at the time of issuance; and
  • has been assigned a Committee on Uniform Security Identification Procedures (CUSIP) number, International Securities Identification Number (ISIN) or other similar designation that identifies a specific security in order to facilitate its trading and settlement.

Newly issued preferred shares and subordinated debt would also be eligible for bail-in, if they do not qualify as non-viability contingent capital ("NVCC") (although in practice, banks are not expected to issue any preferred shares and subordinated debt that do not qualify as NVCC).

The bail-in power will only apply with respect to debt obligations that are issued on or after the day on which the Regulations come into force, or, in the case of a liability issued before such day, the terms of the liability are, on or after that day, amended to increase its principal amount or to extend its term to maturity.

If a debt obligation is partially secured at the time of issuance, only the portion of the principal amount and accrued and unpaid interest of the debt obligation that exceeds the value, determined at the time that the debt obligation is issued, of the collateral is eligible for bail-in.

The following are expressly excluded from the scope of the bail-in power:

(a) covered bonds;

(b) eligible financial contracts;

(c) structured notes;

(d) conversion or exchange privileges that are convertible at any time into shares;

(e) any option or right to acquire shares or any privilege referred to in paragraph (d); and

(f) any share of a series that was created before January 1, 2013 and issued as a result of the exercise of a conversion privilege under the terms attached to another series of shares that was created prior to that date.

A bail-in conversion must meet the following parameters:

  1. Adequate recapitalization — in carrying out a bail-in, CDIC must take into consideration the requirement in the Bank Act for banks to maintain adequate capital.
  2. Order of conversion — bail-in eligible instruments can only be converted after all subordinate ranking bail-in eligible instruments and NVCC have been converted.
  3. Treatment of equally ranking instruments — equally ranking bail-in eligible instruments must be converted in the same proportion and receive the same number of common shares per dollar of the claim that is converted.
  4. Relative creditor hierarchy — holders of bail-in eligible instruments must receive more common shares per dollar of the claim that is converted than holders of subordinate ranking bail-in eligible instruments and NVCC that have been converted.

Bank Recapitalization (Bail-in) Issuance Regulations

To facilitate the enforceability of CDIC's bail-in conversion powers (particularly in the cross-border context), this regulation would require that bail-inable instruments indicate in their contractual terms that the holder of the instrument is bound by the application of the CDIC Act, including the conversion of the instrument into common shares under the bail-in power. As well, it would be required that these contractual terms be governed by Canadian law, even where the rest of the contract is governed by foreign law.

To ensure investors have clarity as to which bank issuances are subject to CDIC's bail-in conversion powers, disclosure that an instrument is eligible for bail-in would be required in the prospectus or other relevant offering or disclosure document.

Compensation Regulations

Under the proposed Compensation Regulations, persons who hold the following claims in the institution[1] at the time of entry into resolution would be entitled to compensation ("Prescribed Persons"): shares of the institution; subordinated debt instruments that were vested in CDIC at the time of entry into resolution; liabilities that were subsequently converted into common shares pursuant to their contractual terms and conditions (e.g., NVCC); liabilities that were subsequently converted into common shares pursuant to the bail-in power; any liability of the institution, if the institution was wound up at the end of the resolution process; and any liability of the institution that was assumed by either a CDIC-owned workout company or bridge institution, which was subsequently liquidated or wound up.[2] The right to compensation would not be transferable.

The amount of compensation to which a Prescribed Person is entitled with respect to each share or liability is determined by the formula A − B − C

where

A is the estimated liquidation value;

B is the estimated resolution value; and

C is

(a) if the share or liability is converted into common shares in accordance with the contractual terms of the share or liability (i.e., NVCC conversion), an amount equal to an estimate of losses attributable to that conversion, and (b) in any other case, zero.

In determining the amount of compensation to which a Prescribed Person is entitled, CDIC is required to consider the difference between the estimated day on which the liquidation value would be received and the estimated day on which the resolution value is, or would be, received.

CDIC would provide a notice to Prescribed Persons with an offer of compensation within a reasonable period of time following the completion of the resolution process. Prescribed Persons would have 45 days to notify CDIC of their acceptance of, or objection to, the offer once received. Failure to notify CDIC would be deemed as an acceptance of the offer.

The Governor in Council is required to appoint a judge as an assessor to review CDIC's determination of compensation if Prescribed Persons who together own at least 10% of the shares of the same class, or at least 10% of the principal amount of the liabilities of the same class, object to CDIC's offer. For the purposes of the Compensation Regulations, shares and liabilities of a federal member institution are of the same class if: (a) in the event of a winding-up of the institution, they rank equally in right of payment; and (b) following the making of the relevant order under the CDIC Act, they receive treatment that is substantially equivalent as a result of the making of the order and any actions taken in furtherance of the order or in accordance with their contractual terms, having regard to the manner in which their resolution value is estimated.

In reviewing CDIC's offer of compensation the assessor would be required to consider whether CDIC's offer was reasonable and consider the same factors as those that CDIC was required to apply when making its initial determination of compensation. CDIC would be required to pay Prescribed Persons their entitled compensation within 90 days of the expiry of CDIC's offer of compensation or the final determination of the assessor.

Draft TLAC Guidance

The draft TLAC Guideline outlines the TLAC requirements that will apply to all D-SIBs. The draft Guideline establishes two minimum standards:

  1. the risk-based TLAC ratio, which builds on the risk-based capital ratios described in the Capital Adequacy Requirements ("CAR") Guideline; and
  2. the TLAC leverage ratio, which builds on the leverage ratio described in OSFI's Leverage Requirements Guideline.

The risk-based TLAC ratio, which will be the primary basis used by OSFI to assess a D-SIB's TLAC, focuses on the risks faced by that institution. The TLAC leverage ratio will provide an overall measure of a D-SIB's TLAC.

Beginning November 1, 2021, OSFI anticipates that D-SIBs will be expected to maintain a minimum risk-based TLAC ratio of at least 21.5% of risk-weighted assets and a minimum TLAC leverage ratio of at least 6.75%. The Superintendent may subsequently vary the minimum TLAC requirements for individual D-SIBs or groups of D-SIBs. D-SIBs will also be expected to hold buffers above the minimum TLAC ratios.

The TLAC measure used in both ratios consists of the sum of the D-SIB's TLAC, subject to certain adjustments. The following will be eligible to be recognized as TLAC:

  • Tier 1 capital, consisting of Common Equity Tier 1 capital and Additional Tier 1 capital;
  • Tier 2 capital; and
  • Prescribed shares and liabilities ("Other TLAC Instruments") that are subject to conversion into common shares pursuant the CDIC Act and meet all of the eligibility criteria set out in the TLAC Guideline, including that the instrument satisfies all of the requirements set out in the Bank Recapitalization (Bail-in) Issuance Regulations.[3]

Changes are also being proposed to the CAR Guideline (primarily to Chapter 2, with consequential amendments to Chapter 1 and 9) to implement the Basel Committee on Banking Supervision's recent amendments to the Basel III standard on the definition of capital to introduce a regulatory capital treatment for banks' holdings of Other TLAC Instruments issued by global systemically important banks ("G-SIBs") that qualify towards their TLAC requirements and instruments ranking pari passu with those instruments. While there are no Canadian G-SIBs, OSFI has determined that it is appropriate to extend the Basel III treatment to holdings of Other TLAC Instruments issued by Canadian D-SIBs.