Bank Recapitalization (Bail-in) Conversion Regulations
Canada Deposit Insurance Corporation Act
Department of Finance
(This statement is not part of the regulations.)
The Canadian financial system remained resilient throughout the 2008 global financial crisis, with no Canadian bank failures. In fact, Canadian banks were able to maintain their access to debt and equity markets throughout the crisis. Today, they are even stronger and better capitalized.
This experience demonstrated the value of Canada’s approach to financial sector regulation and supervision. Nevertheless, the crisis further highlighted that some banks are “systemically important” — so important to the functioning of the financial system and economy that they cannot be wound down under a conventional bankruptcy and liquidation process (should they fail) without imposing unacceptable costs on the economy. These institutions are commonly labelled as “too-big-to-fail.”
Faced with inadequate tools to deal with failed major banks, many authorities in other jurisdictions were forced to rely on taxpayer-funded capital injections to support these institutions in the interests of broader financial and economic stability.
In addition to the direct costs to taxpayers associated with these bailouts, the expectation of a bailout if the bank were to fail gives the banks’ managers an incentive to take on excessive risk, as they would receive all of the potential benefits, but bear only some of the potential costs.
The expectation of a bailout also allows systemically important banks to borrow on more favourable terms, as creditors view the bank’s debt as implicitly guaranteed by taxpayers. By contrast, small and medium-sized banks do not benefit from this implicit subsidy in the form of lower funding costs, as there is less of an expectation that they would be bailed out should they fail.
Government intervention is needed to address the risks to financial stability, the broader economy, and taxpayers, associated with systemically important banks, as outlined above.
Canada has been an active participant in the G20’s financial sector reform agenda aimed at addressing the factors that contributed to the crisis. This includes international efforts to address the potential risks to the financial system and broader economy of institutions perceived as “too-big-to-fail.”
International response to “too-big-to-fail”
Recognizing the cross-border impacts of both financial crises and the market distortions caused by bailouts, G20 members and the Financial Stability Board (see footnote 1) set out a global financial sector reform agenda to (i) reduce the probability of a crisis, and (ii) enhance the capacity to deal with troubled financial institutions in a crisis. Ending “too-big-to-fail” is a key component of this agenda. One of the primary tools for addressing “too-big-to-fail” is bail-in — namely the power for domestic authorities to convert some of a failed bank’s debt into equity to recapitalize the bank and help restore it to viability without the use of government bailouts.
Canada’s framework for domestic systemically important banks
Consistent with the G20 reform agenda, Canada has taken a number of steps since the financial crisis to strengthen the banking sector and reduce the probability and impact of bank failures. This has included implementing international standards to improve the quantity and quality of banks’ capital.
In addition, Canada has been implementing a number of measures aimed specifically at the risks posed by systemically important banks. Canada’s six largest banks (see footnote 2) were named as systemically important by the Office of the Superintendent of Financial Institutions (OSFI) in 2013.
A number of elements of this framework have been implemented. These consist of higher capital requirements, enhanced supervision by OSFI and institution-specific recovery plans and resolution plans. Implementation of a bail-in regime is the key outstanding element of the framework.
Bank resolution in Canada
The Canada Deposit Insurance Corporation (CDIC) is Canada’s federal deposit insurer and resolution authority for its member institutions. CDIC has a number of resolution tools that can be used to manage the potential failure of a member institution, including a systemically important bank.
CDIC’s existing resolution tools include the following:
- Liquidation and reimbursement of insured deposits, whereby the bank is wound up under a court- supervised liquidation and insured deposits are reimbursed to depositors.
- Forced sale, whereby the bank is placed under temporary CDIC control to complete its sale, merger or restructuring. There are the following two types of forced sales:
- Shares and subordinated debt of the bank are transferred to CDIC and it becomes the sole shareholder to facilitate the sale.
- CDIC is appointed receiver to complete a sale of all or some of the bank’s assets and/or an assumption of its liabilities.
- Bridge bank, whereby the bank is placed under temporary CDIC control (i.e. CDIC is appointed receiver of the bank) and CDIC transfers certain assets, liabilities (including at a minimum all insured deposits) and critical functions to a bridge bank, which is temporarily owned by CDIC. The bridge bank can operate, with Governor in Council approval, for up to five years before it must be sold or wound up.
Bail-in regime for banks — Legislative framework
To strengthen Canada’s bank resolution toolkit, Budget 2016 announced that the Government would implement a bail-in regime for Canada’s systemically important banks. The regime would allow authorities to convert shares (e.g. preferred shares) and liabilities (as set out in regulation) of a failing systemically important bank into common shares to recapitalize the bank and allow it to remain open and operating. A legislative framework for the bail-in regime was put in place via amendments to the Bank Act and Canada Deposit Insurance Corporation Act (CDIC Act) as part of Budget Implementation Act, 2016, No. 1 (BIA 1 2016), which received royal assent on June 22, 2016.
Specifically, BIA 1 2016 included amendments to
- permit the Superintendent to formally designate individual banks to which the bail-in regime would apply as “domestic systemically important banks”;
- provide new powers for CDIC to undertake a bail-in by converting eligible shares and liabilities of a non-viable domestic systemically important bank into common shares;
- enhance CDIC’s powers that are necessary to resolve a failed bank and to undertake a bail-in conversion — including powers for CDIC to take temporary control or ownership of a failed bank;
- provide for an updated process for bank shareholders and creditors to seek redress (or “compensation”) should they be left worse off as a result of CDIC’s actions to resolve a failed bank (including, but not limited to, bail-in) than they would have been if the bank had been liquidated; and
- require domestic systemically important banks to maintain a minimum amount of “total loss absorbing capacity” or “TLAC.” The TLAC requirement is aimed at ensuring that these banks have sufficient equity and loss-absorbing liabilities to withstand severe, but plausible, losses and be restored to viability. It would be met through additional regulatory capital [notably equity and non-viability contingent capital (NVCC) preferred shares and subordinated debt (see footnote 3)] and debt eligible for conversion under the new bail-in conversion power. The TLAC requirement is to be set by the Superintendent.
The legislative framework provides for regulations to be made to set out
- the scope of bank shares and liabilities that would be eligible for bail-in;
- conversion terms if a bail-in were to be executed;
- issuance requirements for bail-in eligible shares and liabilities; and
- an updated compensation process for bank shareholders and creditors (see above) affected by CDIC’s actions to resolve a non-viable bank (including, but not limited to, bail-in).
The objectives of the bail-in regime, and by extension, the proposed regulations, are to
- preserve financial stability by empowering the Governor in Council and CDIC to quickly restore a failed systemically important bank to viability and allow it to remain open and operating, even where the bank has experienced severe losses;
- reduce government and taxpayer exposure in the unlikely event of a failure of a systemically important bank; and
- reduce the likelihood of a failure of a systemically important bank and increase market discipline by reinforcing that bank shareholders and creditors are responsible for the bank’s risks — not taxpayers.