Why has no bank issued any subordinated debt or preferred shares in 2013?
As of October 31, 2012, the six largest banks in Canada had approximately $68 billion1 of non-common capital instruments outstanding and routinely issued over $8 billion per year to help fund the growth in the banks’ balance sheets and to fund ongoing redemption of subordinated debt and preferred shares. However, to date in 2013, there has not been one single offering of subordinated debt or preferred shares by a Canadian bank. This article discusses the reasons for the dramatic change.
Almost two and a half years ago, the Basel Committee released new requirements that all non-common capital instruments issued on or after January 1, 2013 must contain provisions that require the instruments to be converted into common shares (so-called non-viable contingent capital, or NVCC) if the relevant regulator determines that the bank is no longer viable. Capital instruments without NVCC features that were outstanding on January 1, 2013 will no longer qualify as capital and are required to be phased out. These transition rules, particularly in the first few years, are quite generous, which significantly decreases the need for new offerings of NVCC-compliant instruments for some time.
Generous Phase-Out Rules for Existing Capital Instruments
The transition rules fix the base of the nominal amount of all non-NVCC-compliant instruments outstanding on January 1, 2013,2 and cap their recognition at 90% commencing on January 1, 2013; the cap is reduced by 10 percentage points each subsequent year. However, when a redemption occurs after January 1, 2013, the nominal base is not reduced for purposes of the calculation. Therefore, if a bank had, say, $1 billion of non-qualifying capital outstanding on January 1, 2013, and redeemed $200 million during 2013, then that $200 million would serve as "amortization shelter," enabling the bank to treat all $800 million of its non-qualifying capital outstanding as eligible until 2015. Given the amount of capital that will be eligible for redemption at par between 2013 and 2015, these transitional rules should permit most, if not all, of the existing outstanding non-qualifying capital to receive full capital credit, especially during the first few years of this transition.
The Importance of Common Share Equity Under Basel III
Under the new Basel III rules, common share equity has become the predominant form of capital, and non-common capital has become less important. As a result, banks have been stockpiling undistributed earnings, which has driven their total capital significantly above minimum required levels. In addition, subordinated debt will become particularly less important in the capital structure when the asset-to-capital multiple becomes based on total tier 1 capital rather than on total capital under the Basel III rules in 2018.
Investor Uncertainty over Future Dilution
In October 2011, the Financial Stability Board (FSB) issued a paper titled "Key Attributes of Effective Resolution Regimes for Financial Institutions." The paper provided that resolution authorities should be able to convert all or part of the unsecured and uninsured creditor claims into equity or other instruments of ownership of the financial institution under resolution in a manner that respected the hierarchy of claims in liquidation. Some observers hoped that this requirement could be satisfied with the bridge banking regime that was inserted into the Canada Deposit Insurance Corporations Act during the financial crisis. However, the peer review of resolution regimes published by the FSB on April 11, 2013 confirmed that bridge banking powers did not by themselves meet the bail-in written resolution powers. In addition, the federal government announced in its April budget plan that it proposed to implement a "bail-in" regime for systemically important banks and that the government would consult with stakeholders on how best to implement the regime in Canada. However, it will likely take at least a year for those consultations to take place and for implementing legislation to be passed by Parliament.
The lack of clarity as to how the bail-in regime will function with NVCC creates uncertainty for potential investors in NVCC instruments because after their instruments are converted into common shares, their position may be significantly diluted further if the bail-in debt trigger is breached.
Cost of Capital Will Increase Significantly
In contrast with other capital innovations over the years, there is no "first mover advantage" for the issuer of NVCC instruments. In fact, it is widely expected that the first issuances of NVCC instruments will require a significantly higher dividend coupon or interest rate to compensate investors for the perceived additional risk over existing instruments. Over time, it is expected that this risk premium will decrease as the market becomes more reassured that the possibility of the trigger event occurring is remote. Therefore, no economic incentive exists for any institution to be the first to spend time and money developing and marketing this new form of capital.
Hope That the NVCC Requirements Would Be Changed
There was some hope in the industry that OSFI might be willing to revisit the contractual NVCC requirements given the refusal of other major jurisdictions (most notably the United States) to impose a contractual NVCC requirement and the linkage between NVCC and bail-in debt (which is expected to be imposed in Canada and other jurisdictions on a statutory basis).3 However, in a speech on May 7, 2009, Mark Zelmer, the Assistant Superintendent at OSFI, made it clear that OSFI will require that all the terms and conditions surrounding the conversion process be clearly spelled out ahead of time in the instrument documentation.4
Concerns About Unintended Consequences
The industry continues to have serious concerns about the possibility of market manipulation and death spirals created through the terms and conditions of NVCC instruments.5 However, the banks continue to work with their advisers to develop terms and conditions that minimize those concerns. Ideally a single structure would be adopted by the industry, which would allow for better understanding and transparency with investors.
In our view, it is unlikely that there will be any issuances of NVCC instruments until at least the fall of this year and possibly not until 2014. We also anticipate that, with the generous phase-out provisions for the existing non-conforming capital and the increased focus on common share equity, it will be a long time before the NVCC instruments will come close to matching the amount of non-common capital outstanding today.
1 According to their annual financial statements prepared as of October 31, 2012, the largest six banks had the following aggregate non-common capital instruments outstanding (including innovative tier 1 capital instruments): Td Bank C$16.963B; RBC C$15.089B; BNS C$16.662B; BMO C$7.020B; CIBC C$8.207B; and NBC C$4.252B.
2 The transition rules are applied separately to non-qualifying tier 1 and tier 2 capital instruments. Capital instruments issued after September 12, 2010 that do not meet one or more of the Basel III criteria for regulatory capital (other than the NVCC requirement) were excluded from regulatory capital effective January 1, 2013.
3 "Should OSFI Rethink Contractual Non-Viable Contingent Capital Requirements?" Torys Bulletin, February 22, 2013.
4 "Let there be light: How more transparency could promote a safer financial system" Remarks by Assistant Superintendent Mark Zelmer of the Office of the Superintendent of Financial Institutions Canada to the BMO First Annual Reserve Management Conference, Toronto, Ontario, May 7, 2009.
5 "Canada Pushes Embedded Contingent Capital” Torys Bulletin, May 28, 2010. Click here to download the PDF.
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