The Government has launched a public consultation on a proposed bail-in regime for Canada's domestic systemically important banks (D-SIBs). The "Taxpayer Protection and Bank Recapitalization" regime (the Proposed Regime) is intended to prevent a tax-payer funded bail-out of a D-SIB by allowing authorities to convert certain debt of a failed bank into regulatory capital. In particular, "long-term senior debt" - defined as senior unsecured debt that is tradable and transferable with an original term to maturity of over 400 days - could be converted into common shares.  The Proposed Regime excludes deposits from the scope of bail-in. The conversion would be accompanied by other actions with the aim of restoring the bank to viability.

Key elements of the Proposed Regime are set out in the TaxpayerProtection and Bank Recapitalization Regime: Consultation Paper (the Consultation Paper) and are summarized below. Comments on the Consultation Paper are to be provided by September 12.

Background

During the global financial crisis, a number of troubled financial institutions considered "too-big-to-fail" were bailed-out by government support. These events gave rise to widespread concern about the cost to taxpayers and the moral hazard resulting from bail-outs. Bail-in is intended to address these problems by ensuring that shareholders and creditors bear losses and by providing a way to recapitalize a failing bank without taxpayers bearing the cost.

Bail-in was included in the Financial Stability Board's Key Attributes of Effective Resolution Regimes for Financial Institutions (the FSB Key Attributes), which were endorsed by the G20 in November 2011. It was announced in the 2013 Budget that a bail-in regime would be introduced for Canada's systemically important banks. For additional background regarding bail-in, please refer to our December 2013 Bulletin Bail-in: Coming to Canada.

Summary of the Consultation Paper

The Proposed Regime and Canada's Bank Resolution Framework

The Proposed Regime would be incorporated into Canada's existing resolution framework for banks. The Consultation Paper makes note of two key elements of this framework: (1) the tools and powers of the Canada Deposit Insurance Corporation (CDIC); and (2) the Non-Viability Contingent Capital (NVCC) regime, which requires non-common capital instruments to include contractual provisions providing for conversion into common shares upon the occurrence of a trigger event. For a summary of the NVCC regime, please refer to our Bulletin OSFI's Final Advisory on Non-Viability Contingent Capital.

It is proposed that bail-in would work in concert with the other elements of Canada's bank resolution framework. In particular, the Consultation Paper states that additional measures such as temporary public control or ownership of the non-viable bank would need to accompany the recapitalization.

Key Features of the Proposed Regime

1) Statutory Conversion Power

The central feature of the Proposed Regime is a statutory power that would allow for the permanent conversion, in whole or in part, of certain liabilities into common shares. This statutory power would also allow for (but not require) the permanent cancellation, in whole or in part, of common shares that were outstanding prior to the point of non-viability.

2) Sequencing and Preconditions

It is proposed that the conversion power could only be exercised following: (a) a determination by the Superintendent of Financial Institutions that the bank is, or is about to become, non-viable; and (b) the full conversion of the bank's NVCC instruments. These would be necessary conditions for the exercise of the conversion power. There would be discretion as to whether to exercise this power when these conditions are met.

3) Scope of Application

It is proposed 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 bail-in. Deposits would be excluded from the bail-in regime. Any preferred shares or subordinated debt issued or renegotiated after the implementation date for the bail-in regime that did not have NVCC terms would also be subject to bail-in (and would be fully converted prior to conversion of long-term senior unsecured debt).

The FSB Key Attributes provide for the bail-in of unsecured and uninsured creditor claims and state that "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 (pari passu) 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."

The Proposed Regime targets a particular subset of unsecured and uninsured claims and excludes other similar ranking claims (e.g., uninsured deposits) from the scope of the bail-in regime. The Consultation Paper states that the proposed scope of the bail-in regime is designed to: (a) minimize impediments to exercising a conversion in a timely fashion; (b) minimize any potential adverse impacts on banks' access to liquidity under stress; and (c) support financial stability.

4) Magnitude of Conversion

The Government proposes that authorities have the flexibility to determine, at the time of resolution, the portion of eligible liabilities that are to be converted into common shares. The decision regarding the total amount of eligible liabilities to be converted would be based on ensuring that the D-SIB was sufficiently recapitalized by the conversion. All long-term senior debt holders would be converted on a pro rata basis (i.e., all creditors within this class would have the same portion of the par value of their claims converted).

5) Conversion Terms

The conversion terms that would apply with respect to eligible liabilities subject to bail-in would be linked to the conversion terms of outstanding NVCC instruments. NVCC instruments are required to include contractual conversion terms that specify a formula for determining how many common shares would be received upon conversion of the instrument. It is proposed that long-term senior debt holders would receive, for each dollar of par value converted, an amount of common shares determined as a fixed multiple 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 fixed conversion multiplier would be set by public authorities in advance. The Consultation Paper provides as an example that a potential range for the conversion multiplier would be 1.1 to 2.0.

As a result of the conversion multiplier, bailed-in debt holders would receive relatively more common shares than former NVCC subordinated debt holders (whose NVCC instruments would have been converted to common shares as a condition for bail-in of long-term debt). This reflects a "relative priority" approach since senior creditors would receive relatively more common shares than subordinated creditors, but subordinated creditors and preferred shares would not be wiped out.

6) Right to 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 liquidated. It is proposed that if shareholders and creditors subject to conversion have been made worse off, they be entitled to compensation. The compensation process would be based on the existing compensation regime in the Canada Deposit Insurance Corporation Act. This is consistent with the FSB KeyAttributes, which provide that "[c]reditors 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..."

7) Disclosure Requirements

The Government proposes that all D-SIBs be required to: (a) include specific disclosures related to the conversion power in any agreement governing an eligible liability as well as any accompanying offering documents; and (b) include a clause in the contractual provisions governing any eligible liability through which investors expressly submit to the bail-in regime, notwithstanding any provision of foreign law to the contrary.

8) A Higher Loss Absorbency Requirement for D-SIBs

It is proposed that D-SIBs be subject to a Higher Loss Absorbency (HLA) requirement to be met via regulatory capital (i.e., common equity and NVCC instruments) and long-term senior debt.

The Government proposes that there be a uniform and public minimum HLA requirement applicable to all D-SIBs and that the Government would retain the discretion to require higher target levels for specific banks where it is deemed necessary for financial stability reasons. The Government proposes that the HLA requirement be between 17% and 23% of risk-weighted assets.

To avoid contagion in the event of a conversion, investments in the long-term senior debt of other banks or in a bank's own long-term senior debt would be deducted from that bank's amount of debt outstanding for the purposes of meeting the HLA requirement.

9) Transition

The Government proposes that the conversion power only apply to liabilities that are issued, originated or renegotiated after an implementation date determined by the Government. There would be no retroactive application to liabilities outstanding as of the implementation date.

It is also proposed that the be a transition period following the initial implementation date before the conversion power comes into force and before D-SIBs are required to meet the HLA requirement.

10) Consumer Deposits

Deposits are excluded from the proposed bail-in regime.

The Consultation Paper notes that the Government plans to undertake a broad review of Canada's deposit insurance framework.

Review of Canada's Bank Resolution Framework

The Government is reviewing CDIC's existing tools and powers in order to determine how best to integrate the conversion power as part of CDIC's toolkit and to ensure that conversion can form part of a robust overall resolution strategy that meets the Government's objectives.

The Consultation Paper states that the incorporation of the conversion power into Canada's resolution toolkit will take into account developments in other jurisdictions. In this regard, the Consultation Paper discusses the U.S. and U.K. approaches to dealing with failing systemically important institutions, both of which relate to institutions with a holding company structure. Canada's D-SIBs are structured so that an operating bank, not a holding company, is the top tier entity in the corporate group. The Consultation Paper states that the Government will consider the merits of a holding company structure for Canadian banks as a means of strengthening the ability to resolve these banks.