Should OSFI Rethink Contractual Non-Viable Contingent Capital Requirements?

Canadian authorities are generally viewed as the primary architects of the non-viable contingent capital (NVCC) requirements that form part of the new Basel III capital regime. However, since those NVCC requirements were adopted, the Financial Stability Board (FSB) has stated that all resolution authorities should have the ability to "bail in" senior debt of a failing bank before taxpayers are exposed to losses. There has been no public commentary as to how those bail-in debt requirements will be adopted in Canada, but other international jurisdictions appear to be favouring a statutory approach. As discussed below, it is almost certain that NVCC instrument conversions and bail-in debt instrument conversions will occur at the same time. It therefore seems logical to include them both in a comprehensive statutory regime to ensure a coordinated and flexible approach for dealing with any bank that may become non-viable. As a result, it may be appropriate for the Office of the Superintendent of Financial Institutions (OSFI) to reconsider its decision that the NVCC requirements should be imposed in Canada contractually rather than as part of a comprehensive statutory regime.

Background

On January 13, 2011, the Basel Committee on Banking released new requirements that all non-common capital instruments (i.e., preferred shares and subordinated debt) issued after January 1, 2013, must  include provisions for those instruments to be either written off or converted into common equity if a bank becomes non-viable (the so-called NVCC requirements). While there are no minutes or other disclosure of the discussions at the meetings of the Basel Committee, it is widely speculated that Canadian authorities were the primary advocates of the NVCC requirements. For example, on April 9, 2010, OSFI published an article in London’s Financial Times advocating the concept. Similarly, on April 13, 2010, Canada’s Minister of Finance wrote to his G20 colleagues with the same message, in advance of hosting a meeting of that group later in the year.

In October 2011, the FSB released a paper entitled "Key Attributes of Effective Resolution Regimes for Financial Institutions". One of the attributes specified in the paper was the power of resolution authorities to write down or convert into equity all or parts of unsecured and uninsured creditors’ claims in a manner that respects the hierarchy of claims in liquidation before governmental authorities (i.e., taxpayers) would be expected to be exposed to loss. In June 2012, the European Commission (EC) released a proposal for a new directive of the European Parliament to require, among other things, that resolution authorities in all member states have the statutory power to bail in certain senior liabilities of an institution. Earlier this month the government of the United Kingdom indicated that it plans to implement the EC’s directive rather than tabling UK-specific legislation at this time. There has been no commentary regarding these matters in the United States, although it is widely believed, that as with the NVCC requirements, the U.S. authorities will take the position that the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) generally satisfy these bail-in debt requirements.

NVCC and Bail-in Conversions Are Inextricably Linked

The OSFI guidance (consistent with the Basel III requirements) provides that the conversion of NVCC  instruments into common shares should occur in either of the following situations:

1. the Superintendent of Financial Institutions (the Superintendent) publicly 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 factors or circumstances that are considered relevant or appropriate, it is reasonably likely that the viability of the institution will be restored or maintained; or
2. a federal or provincial government in Canada publicly announces that the institution 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 institution would have been determined by the Superintendent to be non-viable.

In order for the Superintendent to form an opinion that it is reasonably likely that the viability of the bank will be restored or maintained after the conversion of the NVCC instruments, it is imperative that significant new capital be injected into the non-viable bank. The mere triggering of the conversion of the non-common capital instruments into common shares does not increase the quantity of capital (only the quality). The banking business is a "confidence" business, and if the primary regulator of the bank announces that the institution with its current level of capital is not viable, a significant amount of additional capital would likely be required in order to restore confidence in the bank.

The additional capital will need to come from either public or private sources. It is unlikely that private sources would be willing to commit the billions of dollars necessary to save a failing bank and restore the confidence of depositors and customers. As a result, the only practical source of such new capital would be the government. Before the new bail-in requirements were announced by the FSB, that may have been a reasonable approach for the government to take. The NVCC conversion would require all the capital providers to the bank to be exposed to losses, and the tier 1 common share equity would have been replenished, which, in turn, would have permitted the government to purchase less risky, non-common capital instruments in the bank. However, with the proposed new bail-in senior debt requirements, any government would likely be heavily criticized both domestically and internationally if it were to inject capital before the senior uninsured and unsecured creditors were also exposed to losses. As a result, it is almost certain that NVCC conversions and bail-in debt conversions will occur at the same time.

Problems Created by Lack of Coordination

The current NVCC requirements published by OSFI require that the conversion formula for NVCC instruments be included in the contractual terms. As noted in previous articles by our firm Canada Pushes Embedded Contingent Capital and Canada Implements Basel III Contingent Capital Requirements, this conversion formula creates, among other things, opportunities for hedge fund and other investors to attempt to "game" the markets to maximize their profits if a bank gets into financial difficulty, and it may significantly increase the likelihood of that bank becoming non-viable. For example, those investors could short-sell the common shares of the bank (thereby driving down the price) and expect to cover their short positions by purchasing subordinated debt. With the common share price falling rapidly, it would be difficult, if not impossible, for the bank to raise new capital to restore confidence. However, if there were no pre-set formula for the number of shares to be received in a conversion of the NVCC instruments, it would be more difficult for investors to influence the outcome. It is for this reason, we understand, that the United States has not adopted a contractual NVCC approach but rather is maintaining that the Orderly Liquidation Authority under Dodd-Frankcreates sufficient flexibility to orchestrate a similar result. We also understand that the EC has recently reconsidered its support of contractual NVCC and now plans to implement the NVCC requirements as part of a statutory regime.

Since the conversions of the NVCC instruments and the bail-in debt instruments would occur simultaneously, it would likely be desirable for them to occur in a coordinated manner. However, with the rigidity of the pre-set formula in the contractual NVCC  instruments, it is difficult to envisage how that could occur. Moreover, since it is impossible to predict in advance the circumstances that might cause a bank to become non-viable, it is difficult to know what type of resolution action would be the most desirable, and therefore maintaining broad discretionary statutory powers for NVCC and bail-in debt resolution tools may be more appropriate in the circumstances. For these reasons, OSFI may wish to rethink its commitment to contractual NVCC conversion and consider moving to a statutory regime.  If that were done, NVCC conversions and bail-in debt conversions would both be dealt with in the same statutory regime, and Canada would then be more in-step with the rest of the international community on these important issues.