The Implementation of the New Non-Viability Contingent Capital Requirements of the Basel III Rules

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1 The Implementation of the New Non-Viability Contingent Capital Requirements of the Basel III Rules In August 2011, the Office of the Superintendent of Financial Institutions (Canada) ( OSFI ) released its Final Advisory (the OSFI Advisory ) on non-viability contingent capital. The OFSI Advisory is one of the most detailed guidelines on the new requirements (the NVCC requirements ) under the Basel III Rules (the Basel III Rules ) published by the Basel Committee on Banking Supervision ( BCBS ) in January 2011 entitled Minimum requirements to ensure loss absorbency at the point of non-viability. The NVCC requirements are in addition to the other criteria applicable to capital instruments specified in Basel III: a Global regulatory framework for more resilient banks and banking systems published by the BCBS on December 6, 2010 (the Basel III Criteria ). The OSFI Advisory was published to provide clarity as to the Basel III Rules and what will be required of banks when the new NVCC requirements come into effect on January 1, Background The purpose of the Basel III Rules is to ensure greater stability of the world s banking institutions by requiring them to hold more capital which would serve as a buffer against losses and reduce the likelihood of bank failures, and, ultimately, government intervention and/or bailouts. The Basel III Rules are intended to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss. The OSFI Advisory outlines OSFI s expectations and objectives with regard to non-common capital instruments issued by banks, bank holding companies, and federally-regulated trust and loan companies (collectively Deposit Taking Institutions, DTIs ), and the implementation of the Basel III Rules.

2 - 2 - Key Concepts The Basel III Rules require that all non-common Tier 1 and Tier 2 capital instruments ( NVCC ) must contain features that require them to be written-off or converted into common equity upon the occurrence of a trigger event at the point of non-viability. It is the way that a DTI s NVCC are classified that will determine their treatment under the new Basel III Rules. Banking institutions maintain a reserve of capital to provide protection against unexpected losses. Unexpected losses are in contrast to expected losses, those covered by banking provisions, reserves, and annual profits. It is the unexpected losses that the Basel III Rules and the OSFI Advisory seek to confront, with a view to ensuring the stability of Canada s banking institutions in the event of any future unexpected market events. A banking institution s financial strength is measured by using Tier 1 capital, composed of core capital. Such core capital consists of common stock and disclosed reserves, as well as some forms of preferred stock. Tier 2 capital includes a number of other constituents of a bank s capital base, and is also referred to as supplementary capital. Tier 2 capital is also heavily regulated, and in the calculation of regulatory capital, Tier 2 is limited to 100% of Tier 1 capital held by a financial institution. Tier 2 capital includes undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid debt/equity capital instruments, and subordinated debt. By requiring all NVCC to be easily convertible to common shares upon a non-viability trigger event experienced by a financial institution, the Basel III Rules create a safeguard against such unexpected losses. This safeguard is to ensure that banking institutions survive non-viability and remain accountable to their shareholders and investors. NVCC Issued Prior to January 1, 2013 Prior to the coming into force of the OSFI Advisory on January 1, 2013, DTIs can continue to issue capital instruments that do not comply with the new NVCC requirements. These instruments must however comply with the Basel III Criteria for inclusion as Additional Tier 1 and Tier 2 capital, up until 2013.

3 - 3 - On January 1, 2013, any outstanding capital instruments not meeting NVCC requirements will be considered non-qualifying capital instruments, and will be subject to a phase-out period. For example, starting on January 1, 2013, existing subordinated debt, innovatives or preferred shares will be subject to phase-out or disqualification unless their terms are amended to include NVCC features. Such amendments are subject to the prior approval of investors. Phase-out is a process that will apply to those instruments that no longer qualify as Additional Tier 1 and Tier 2 capital. To accomplish this phase-out, the pool of the non-qualifying instruments will be fixed at the nominal amount of those instruments outstanding on January 1, Their recognition will be capped at 90% from January 1, 2013, with the cap reducing by 10% each subsequent year. This is expected to be applied to Tier 1 and Tier 2 capital separately and refers to the total amount of instruments outstanding and not individual instruments. Once this phase out is complete, these instruments will be disqualified from the conversion process. If DTIs wish to issue NVCC compliant instruments prior to the coming into effect date above, then they are entitled to do so. This will afford DTIs with time to structure and market instruments and address any possible obstacles that arise with regard to issuance. Conversion to common shares as the preferred method OSFI favours conversion as the tool to pre-empt any potential banking crises primarily as a result of investor feedback received by both OSFI and BCBS. Conversion is an alternative to liquidation or bankruptcy and preserves the hierarchy of claimants as there is a significant dilution of original common shareholders via the issuance of new shares to holders of NVCC, and by virtue of the fact that Tier 2 NVCC investors receive more shares than Tier 1 NVCC investors. Triggering Conversion of NVCC: Relevant Criteria The OSFI Advisory has listed at least seven indicative criteria for DTIs to consider in making the determination of whether their capital instruments are, in fact, non-viable. This determination will be made through OSFI s interaction with the Financial Institutions Supervisory Committee,

4 - 4 - which is comprised of OSFI, the Canada Deposit Insurance Corporation, the Bank of Canada, the Department of Finance, and the Financial Consumer Agency of Canada. These criteria include: whether the DTI s assets are insufficient to cover their liabilities; whether the DTI has lost the confidence of depositors, creditors and/or the public; whether the level of capital has materially eroded; whether the DTI has failed to pay any liability that has become due and payable, or whether the DTI will be unable to pay its liabilities as they become due and payable; whether the DTI has failed to comply with an order to increase capital; whether there is any other state of affairs that is materially prejudicial to the interests of depositors and creditors; and whether the DTI can recapitalize on its own, where there are no private or public investors willing to inject capital. These criteria are by no means exhaustive and come from pre-existing legislation relating to the Superintendent either taking control of a financial institution or rather simply making a nonviability determination. NVCC Trigger Events The OSFI Advisory requires that the terms and conditions of all non-common Tier 1 and Tier 2 instruments must include provisions whereby the instrument is either written off or converted into common equity upon the occurrence of the trigger event at the point of non-viability.

5 - 5 - Such trigger events are either a public announcement by the Superintendent to the effect that the DTI has been advised that the Superintendent is of the opinion that the DTI has ceased to be viable, or when a Canadian federal or provincial body publicly announces that a DTI has accepted or agreed to accept a capital injection or equivalent support. Information Requirements to Confirm Quality of NVCC Instruments The OSFI Advisory includes an extensive list of factors for DTIs to consider when confirming their capital quality. Prior to the issuance of any NVCC instruments, either before of after January 1, 2013, such factors must be taken into account and changes made, where needed. Some of the information that the DTI is expected to provide to OSFI in connection with their request for capital quality confirmation includes: (i) draft terms of the NVCC instruments, (ii) tax, accounting, and legal opinions, (iii) a description outlining the rationale for the specified conversion method, (iv) where the terms of the instrument provide for triggers in addition to those noted above, the rationale for those additional triggers and market analysis of possible implications of their use, and (v) an assessment of the features of the proposed capital instrument against the minimum criteria for inclusion in Additional Tier 1 capital or Tier 2 capital (as set out in Basel III) and the principles for NVCC instruments set out in the OSFI Advisory. General Principles of Compliance Governing NVCC The Basel III Rules provide a number of principles of compliance intended to assist DTIs with implementing the new requirements for NVCC. These principles must be satisfied in their entirety by January 1, 2013 in order for all non-common Tier 1 and Tier 2 capital instruments issued by DTIs to be in full compliance with the NVCC requirements. 1. In their contractual terms and conditions, all existing and newly issued non-common Tier 1 and Tier 2 capital instruments must have a clause requiring full and permanent conversion into common shares of the DTI upon a trigger event.

6 NVCC instruments must also meet all other criteria for inclusion under their respective tiers as specified in the Basel III Criteria. Depending on the terms and conditions, the NVCC instrument will be classified as either a Tier 1 or Tier 2 capital instrument. 3. The contractual terms of all Additional Tier 1 and Tier 2 capital instruments must include at minimum the trigger events noted above in preparation for January 1, The conversion terms of new NVCC instruments must reference the market value of common equity on or before the date of the trigger event. A limit or cap on the number of shares issued upon a trigger event must also be included in the conversion method used. 5. The conversion method must take into account the hierarchy of claims in liquidation and result in the significant dilution of pre-existing common shareholders. The required conversion should demonstrate that former subordinated debt holders receive economic entitlements that are more favourable than those provided to former preferred shareholders, and that former preferred shareholders receive economic entitlements that are more favourable that those provided to pre-existing common shareholders. Historically, under most liquidations and resolution scenarios, common and preferred shareholders have been fully written off whereas subordinated debt holders have experienced deep losses. With the new NVCC regime, there will be more effective recoveries, in which the Loss Given Failure or Default ( LGF/LGD ) would be better for NVCC investors than otherwise because of the equity benefits associated with the common shares of a financial institution that the government has maintained as a going concern. NVCC is most appealing to investors as this conversion process exposes investors to losses but they may never actually realize any losses and could potentially experience gains. Under this regime, investors receive at least par value in common shares, and so it is a system that investors may support.

7 The DTI must ensure that there are no impediments to the automatic and immediate conversion of capital instruments in the event of non-viability after January 1, This includes the DTI guaranteeing that there are enough common shares available for the conversion of NVCC instruments, which is done by ensuring that: (a) the DTI s by-laws or other relevant constating documents permit the issuance of common shares upon conversion without the prior approval of existing capital providers as well as the requisite number of shares to be issued upon conversion; (b) the terms and conditions of any other agreement do not require the prior consent of the parties in respect of the conversion; (c) the terms and conditions of capital instruments do not impede conversion; and (d) if applicable, the DTI has obtained all prior authorization, including regulatory approvals and listing requirements, to issue the common shares arising upon conversion. 7. It must be specified in the terms and conditions of the NVCC that conversion does not constitute an event of default under that instrument creating the same. The DTI must also ensure that such conversion does not result in a cross-default or other credit event under any other agreement entered into by the DTI after the issuance of the OSFI Advisory. Such specifications should be included by January 2013 to ensure that there is no default in the event of conversion. 8. The non-common capital instrument s terms should include provisions to address NVCC investors that are prohibited from acquiring shares in the DTI upon a trigger event, pursuant to the legislation governing the DTI. These mechanisms should enable these capital providers to comply with legal prohibitions while continuing to receive the economic results of common share ownership and should allow such persons to transfer their entitlements to a person permitted to own shares in the DTI.

8 For DTIs, including Schedule II banks that are subsidiaries of foreign financial institutions subject to Basel III Criteria, any NVCC issued by the DTI must be convertible into common shares of the DTI or convertible into common shares of the DTI s parent or affiliate, subject to the prior consent of OSFI. In this case, trigger events in a DTI s NVCC instruments cannot include triggers that are at the discretion of a foreign regulator or that are based on events applicable to an affiliate, such as an event in the home jurisdiction of a DTI s parent. 10. For those DTI s which have subsidiaries in foreign jurisdictions subject to the Basel III Criteria, the DTI may, to the extent permitted, include the NVCC issued by foreign subsidiaries in the DTI s consolidated regulatory capital, provided that such foreign subsidiary s NVCC complies with the requirements of the rules of the host jurisdiction. NVCC instruments issued by foreign subsidiaries must include in their contractual terms triggers that are equivalent to those noted above. OSFI will only activate those foreign triggers after consultation with the host authority where: (i) the subsidiary is non-viable as determined by the host authority, and (ii) the parent DTI is, or would be, non-viable, as determined by OSFI, as a result of providing or committing to provide a capital injection or similar support to the subsidiary. Looking Ahead DTIs must take steps to ensure that they are in full compliance with the Basel III Rules by January 1, In the event that any provisions are not in place by that date, and a non-viability event occurs, there could be significant negative consequences for a DTI s investors and shareholders. It is therefore necessary that full-compliance with the Basel III Rules is achieved well in advance of the Basel III Rules coming into effect. This is an area of banking regulation that is complicated and has wide-ranging implications. It is thus important to consult with those experts in the field who can provide solutions for how best to implement these reforms so that

9 - 9 - any defaults or losses are kept to a minimum, while these regulatory requirements take effect to ensure the financial stability of Canada s banking institutions. For any other information or to discuss further, please contact one of the authors.