Bill C-15 Implements Bank Recapitalization Regime

On April 20, 2016, the Government of Canada introduced Bill C-15, which implements certain provisions of the budget tabled in Parliament on March 22, 2016. One of those provisions relates to the creation of a bank recapitalization (or "bail-in") regime which has been a focus of the Government for a couple of years in accordance with expectations established by the Financial Stability Board.¹

What You Need To Know

The key features of the Bank Recapitalization (Bail-In) Regime implemented through Bill C-15 include:

• the Government will have a statutory power to direct the Canada Deposit Insurance Corporation (CDIC) to convert specified eligible shares and liabilities of "domestic systemically important banks" into common shares in the event such bank becomes non-viable;
• the types of instruments subject to the conversion power will be set out in regulations to the Canada Deposit Insurance Corporation Act which have not yet been prescribed (but the expectation is that these instruments will include senior unsecured debt that is tradable and transferable with an original term to maturity of over 400 days, consistent with the Government’s proposal in a consultation paper released in 2014);
• the conversion power will not apply to liabilities outstanding on the date the regulation comes into force – it will only apply to liabilities issued after that time;
• the conversion power will not apply to insured or uninsured deposits of the bank;
• subject to any regulations or by-laws, the CDIC shall set the terms and conditions of a conversion, including its timing; and
• each domestic systemically important bank will be required to maintain a minimum capacity to absorb losses consisting of regulatory capital and debt which is subject to the conversion power.

Overview

The purpose of the bail-in regime is to allow for the expedient conversion of certain bank liabilities into regulatory capital in the highly unlikely event that a domestic systemically important bank (D-SIB) becomes non-viable. It is aimed at ensuring that (a) taxpayers are protected from having to bail out a D-SIB in the highly unlikely event of such an institution running into financial difficulty; and (b) Canada’s financial system remains strong by clarifying that banks’ shareholders and creditors are responsible for bearing losses, thereby giving them stronger incentives to monitor the bank’s risk-taking activities.

In order to achieve its policy objectives, Bill C-15 amends the Canada Deposit Insurance Corporation Act (the "CDIC Act") to, among other things, broaden the Canada Deposit Insurance Corporation’s (CDIC) powers to temporarily control or own a D-SIB² and to convert certain shares and liabilities of such a bank into common shares. Some of the key features of the regime are noted below.

Statutory Conversion Power

The cornerstone of the regime is that the Government will have a statutory power to direct the CDIC to convert, in whole or in part, specified eligible shares and liabilities into common shares of the D-SIB (or its affiliates). We would expect a conversion to occur following a determination by the Superintendent of Financial Institutions that the bank has ceased, or is about to cease, to be viable, and a full conversion of the bank’s non-viability contingent capital (NVCC) instruments.

Unfortunately, the new provisions to the CDIC Act only permit conversions into common shares of the D-SIB as opposed to providing flexibility to convert into preferred shares or subordinated debt. We believe that providing flexibility to convert into other forms of capital would have been more appropriate, as it would have allowed the D-SIB to retain a more traditional and efficient capital structure post-conversion.

While there were rumblings that the new power might also potentially allow for the permanent cancellation of common shares of the bank which were outstanding prior to the point of non-viability, the CDIC Act amendments do not contain such a power. We believe that this is positive, as there could have been unintended consequences of cancelling common shares, such as the potential to significantly negatively affect the D-SIB’s ability to raise common share capital in the recovery phase if there was a possibility that those shares could be cancelled by the regulatory authority.

Affected Instruments

The types of shares and liabilities subject to the conversion will be set out in regulations to the CDIC Act. While these regulations have not yet been prescribed, in the Government’s 2014 consultation paper, it had proposed that "long-term senior debt" – senior unsecured debt that is tradable and transferable with an original term to maturity of over 400 days – would be subject to conversion through the exercise of the statutory conversion power. Deposits, however, would specifically be excluded from the regime.

As per the CDIC Act amendments, the regime does not apply retroactively to shares or liabilities outstanding as of the day the regulation comes into force, although to the extent such instruments are amended or extended following such date, they would then be subject to the conversion provisions.

Magnitude of Conversion and Conversion Terms

The CDIC Act amendments provide that, subject to any regulations or by-laws, the CDIC shall set the terms and conditions of the conversion, including its timing. As a result, assuming that the regulations or by-laws do not prescribe the magnitude of conversion, the CDIC would have the flexibility to determine, at the time of resolution, the portion of eligible securities to be converted into common shares.

Similarly, the CDIC would have the flexibility to determine the number of common shares that would be provided for each dollar of par value of a claim that is converted, which we view as positive, assuming the regulations and by-laws do not prescribe a fixed conversion multiplier. We do not believe that it would be desirable to prescribe a fixed conversion multiplier, as a fixed conversion multiplier would limit flexibility which is necessary in order to respect the hierarchy of claims and would also present significant "arbitrage" risk. In addition, the CDIC Act amendments provide that the by-laws may permit the conversion of the eligible instruments into interim instruments before being converted into common shares (which also decreases the need for a fixed multiplier as it would give the CDIC time to develop the conversion ratio during resolution).

Right to Compensation

Conversion of eligible liabilities is subject to the principle that no creditor be worse off as a result of conversion than they would have been in a traditional liquidation. Specifically, the CDIC Act amendments provide that any creditors who are in a worse financial position than they would have been had the D-SIB been liquidated under the Winding Up and Restructuring Act are entitled to be paid compensation. The amount of compensation to be paid to such a creditor will be determined in accordance with the regulations and by-laws, which have not yet been prescribed.

New Capital Requirements

In addition to amendments to the CDIC Act, Bill C-15 also amends the Bank Act to allow the designation of D-SIBs by the Superintendent of Financial Institutions and to require such banks to maintain a minimum capacity to absorb losses consisting of regulatory capital and liabilities which are subject to the conversion power (which minimum amount would be published in the Canada Gazette). The purpose of the new requirement is to ensure D-SIBs have sufficient loss-absorbing capacity to withstand severe, but plausible, losses and emerge from a conversion adequately capitalized with a buffer above target capital requirements.

The amount of capital and prescribed shares and liabilities that constitutes each bank’s minimum capacity to absorb losses will be determined by the Superintendent of Financial Institutions in consultation with members of a committee established under s. 18(1) of the Office of the Superintendent of Financial Institutions Act.

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¹ The Government of Canada published a consultation paper on August 1, 2014 on a proposed bail-in regime applicable to Canada’s domestic systemically important banks (D-SIBs).

² CDIC currently has a number of tools and powers to assist or resolve its member institutions, including forced sales (either share-based or asset-based) and bridge bank.