On August 7, 2012, the Office of the Superintendent of Financial Institutions Canada (OSFI) released for comment a revised Capital Adequacy Requirements Guideline (the Guideline). This Guideline applies to banks and federally regulated trust or loan companies and to bank holding companies incorporated or formed under the Bank Act (Canada) (referred to as banks or institutions in this update). The Guideline is being revised as a result of the Basel Committee on Banking Supervision (the BCBS) reforms to strengthen global capital rules with the goal of promoting a more resilient banking sector, commonly referred to as Basel III. The comment period ends on September 28, 2012.
In response to the financial crises that began in 2008, on September 12, 2010, the Group of Governors and Heads of Supervision, the international oversight body of the BCBS, announced the agreements reached in connection with the new rules (known as Basel III) required to strengthen the resilience of banks and the global banking system. On December 16, 2010, the BCBS released the Basel III rules relating to new international bank capital adequacy rules and rules for minimum and appropriate forms of bank liquidity. For Basel III rules to apply to Canadian institutions, the new rules have to be implemented by OSFI. The purpose of the Guideline is to implement the Basel III rules.
The capital standards set out in the Guideline are meant to provide the framework within which OSFI assesses whether an institution maintains adequate capital. For this purpose, OSFI has established two minimum standards: the assets to capital multiple, and the risk-based capital ratio. The first test provides an overall measure of the adequacy of an institution's capital. The second measure focuses on risk faced by the institution. The Guideline states that BCBS is currently finalizing a leverage ratio requirement with implementation planned in the first fiscal quarter of 2018. Pending review of the final leverage requirements, institutions are expected to continue to meet an assets to capital multiple test and to operate at or below their authorized multiple on a continuous basis.
The revised Guideline addresses a number of issues related to the banks' capital requirements which will impact the above-mentioned standards. These include the following: (i) raising the quality of capital to ensure banks are better able to absorb losses, (ii) raising the level of the minimum capital requirements, and (iii) promoting the build-up of capital buffers in good times that can be drawn down in periods of stress. Below is a brief overview of the new capital requirements.
The current Guideline consists of two documents, Guideline A for institutions using the simpler approaches and Guideline A-1 encompassing all approaches. Guideline A and A-1 are being consolidated into a single guideline and each chapter is now presented as a separate document with a detailed table of contents. Institutions using the simpler approaches will only need to refer to the chapters relevant to their capital adequacy measures.
What will qualify as Regulatory Capital?
Under the revised Guideline, total capital consists of the sum of the following elements: (i) Tier 1 capital, consisting of Common Equity Tier 1 capital and Additional Tier 1 capital, and (ii) Tier 2 capital. Tier 3 capital has been eliminated.
Common Equity Tier 1 Capital
Common Equity Tier 1 capital consists of the sum of the following elements: (a) common shares issued by the institution that meet the criteria for classification as common shares for regulatory purposes; (b) contributed surplus (share premium) resulting from the issuance of instruments included in Common Equity Tier 1; (c) retained earnings; (d) accumulated other comprehensive income and other disclosed reserves; and (e) common shares issued by consolidated subsidiaries of the institution and held by third parties that meet the criteria for inclusion in Common Equity Tier 1 capital. Dividends will be removed from Common Equity Tier 1 in accordance with applicable accounting standards.
The Guideline sets out certain criteria that must be met for an instrument to be considered as Common Equity Tier 1 capital. None of these criteria would be considered novel when compared to the terms of common shares currently issued by Canadian financial institutions.
Additional Tier 1 instruments
Under OSFI's existing capital rules, a number of Canadian financial institutions have issued preferred shares and innovative Tier 1 instruments which at the time of their issuance qualified as Additional Tier 1 instruments. Under the new rules, such preferred shares will not qualify as Additional Tier 1 instruments because their terms do not include a clause (Conversion Clause) requiring the full and permanent conversion of such preferred shares into common shares at the point of non-viability as described under OSFI's non-viability contingent capital (NVCC) requirements. Similarly, under the new rules, the currently issued innovative Tier 1 instruments will not qualify as Additional Tier 1 instruments because their terms do not also include a Conversion Clause. In addition, such innovative Tier 1 instruments have typically been issued by special purpose vehicles (SPVs) of Canadian institutions and the instruments issued by the Canadian institutions to such SPVs will not satisfy the requirements under the new capital rules. To see the minimum set of criteria for an instrument issued by an institution to meet or exceed in order for it to be included in Additional Tier 1 capital, see Annex A.
Tax and Regulatory Event Calls: Under the revised Guideline, tax and regulatory event calls will be permitted within the first years of an instrument's life subject to the prior approval of the Superintendent and provided the institution was not in a position to anticipate such an event at the time of issuance.
Dividend Stopper: Dividend stopper arrangements that stop payments on common shares or other Additional Tier 1 instruments will also be permissible provided the stopper does not impede the full discretion the institution must have at all times to cancel distributions or dividends on the Additional Tier 1 instrument, nor must it act in a way that could hinder the recapitalization of the institution pursuant to criterion # 13 in Annex A. For example, a stopper on an Additional Tier 1 instrument will not be permitted to: (a) attempt to stop payment on another instrument where the payments on the other instrument were not also fully discretionary; (b) prevent distributions to shareholders for a period that extends beyond the point in time that dividends or distributions on the Additional Tier 1 instrument are resumed; or (c) impede the normal operation of the institution or any restructuring activity, including acquisitions or disposals. A dividend stopper may also act to prohibit actions that are equivalent to the payment of a dividend, such as the institution undertaking discretionary share buybacks.
Tier 2 Capital
Tier 2 capital will consist of the following elements: (a) instruments issued by the institution that meet the criteria for inclusion in Tier 2 capital (and are not included in Tier 1 capital); (b) contributed surplus (share premium) resulting from the issuance of instruments included in Tier 2 capital; (c) instruments issued by consolidated subsidiaries of the institution and held by third parties that meet the criteria for inclusion in Tier 2 capital and are not included in Tier 1 capital; and (d) certain loan loss allowances as specified in the Guideline. The subordinated debt currently issued by Canadian financial institutions will not qualify as Tier 2 Capital under the new capital rules because their terms do not include a Conversion Clause. To see the minimum set of criteria for an instrument issued by an institution to meet or exceed in order for it to be included in Tier 2 capital, see Annex B.
Tax and Regulatory Event Calls: Tax and regulatory event calls will be permitted within the first years of an instrument's life subject to the prior approval of the Superintendent and provided the institution was not in a position to anticipate such an event at the time of issuance.
Acceleration Clauses: Tier 2 capital instruments must not contain restrictive covenants or default clauses that would allow the holder to trigger acceleration of repayment in circumstances other than the insolvency, bankruptcy or winding-up of the issuer.
Governing Law: The debt agreement must normally be subject to Canadian law. However, the Superintendent may waive this requirement, in whole or in part, provided the institution can show that an equivalent degree of subordination can be achieved as under Canadian law. In all cases, the prior consent of the Superintendent must be obtained where law other than Canadian law will apply.
Purchase for Cancellation: Purchase for cancellation of Tier 2 instruments is permitted at any time with the prior approval of the Superintendent.
Tier 2 Capital Instruments issued to a Parent: Privately held banks will be permitted to have Tier 2 capital instruments issued to their parent entities provided that, in addition to complying with the qualifying criteria and minimum requirements specified in the Guideline, the issuing bank when providing notification of the intercompany issuance to OSFI includes the following: (a) a copy of the instrument's term and conditions; (b) the intended classification of the instrument for regulatory capital purposes; (c) the rationale provided by the parent for not providing common equity in lieu of the subject capital instrument; (d) confirmation that the rate and terms of the instrument are reasonable; and (e) confirmation that the failure to make dividend or interest payments, as applicable, on the subject instrument would not result in the parent, now or in the future, being unable to meet its own debt servicing obligations nor would it trigger cross-default clauses or credit events under the terms of any agreements or contracts of either the institution or the parent.
Non-Viability Contingent Conversion
Under the Guideline, the most significant change relevant to Canadian financial institutions that will come into effect as a result of the Basel III requirements is the requirement (the NVCC requirement) that all non-common share Tier 1 capital instruments (such as preferred shares) and Tier 2 capital instruments (such as subordinated debt) must have, in their contractual terms and conditions, a clause requiring a full and permanent conversion (the Non-Viability Contingent Conversion) into common shares of the financial institution upon the occurrence of a trigger event. The revised Guideline sets out certain principles that must be followed by Canadian financial institutions to satisfy the NVCC requirement. These principles are set out in Annex C. While all these principles must be carefully reviewed to ensure that any capital instruments issued by an institution comply with these principles, Principle #4 in particular will be important especially for privately held banks whose common equity is not easily ascertainable. We expect OSFI to provide additional guidance for privately held banks to facilitate compliance with these principles.
How much Regulatory Capital will be required?
Minimum Capital Requirements
The Guideline contains the following table which provides the minimum Common Equity Tier 1, total tier 1 and total capital ratios before application of the new capital conservation buffer. The ratios between 2013 and 2019 include phase-in of certain regulatory adjustments and phase-out of non-qualifying capital instruments as outlined in the Guideline.
Capital Conservation Buffer
In addition to the minimum capital ratios, institutions will be required to hold a capital conservation buffer. The capital conservation buffer is designed to establish a safeguard above the minimum capital requirements and can only be met with Common Equity Tier 1 capital. The capital conservation buffer will be phased-in between 2016 and 2019 and when fully transitioned the buffer will be 2.5% of risk weighted assets. Institutions should maintain the minimum Common Equity Tier 1 capital ratio, total tier 1 capital ratio and total capital ratio plus the capital conservation buffer. The table below sets out the levels of capital conservation buffer that will be required commencing in 2016.
Commencing January 1, 2016, if an institution's capital ratios fall below the levels set out in Table 2, in the absence of other remedial actions to improve its capital ratios, capital conservation ratios will be imposed that limit distributions. These limits increase as an institution's capital levels approach the minimum requirements.
Table 3 sets out the capital conservation ratio an institution must meet at various levels of Common Equity Tier 1 capital. Once imposed, conservation ratios will remain in place until such time as capital ratios have been restored.
Items considered to be distributions include dividends and share buybacks, discretionary payments on other tier 1 capital instruments and discretionary bonus payments to staff. Payments that do not result in depletion of Common Equity Tier 1 (e.g., stock dividends) are not considered distributions.
OSFI expects all institutions to attain target capital ratios equal to or greater than the 2019 minimum capital ratios plus conservation buffer level early in the transition period. For all institutions this means an "all-in" target Common Equity Tier 1 (CET1) ratio of 7% by the first quarter of 2013. Further, OSFI expects all institutions to attain "all-in" target capital ratios of 8.5% for total tier 1 and 10.5% for total capital by the first quarter of 2014 (see Table 4 below).
The Guideline provides that these "all-in" targets are applicable to all institutions and are triggers for supervisory intervention. The Superintendent may set higher target capital ratios for individual institutions or groups of institutions where circumstances warrant.
- Issued and paid-in in cash or, subject to the prior approval of the Superintendent, in property.
- Subordinated to depositors, general creditors, and/or subordinated debt holders of the institution.
- Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis the institution's depositors and/or creditors.
- Is perpetual, i.e. there is no maturity date and there are no step-ups or other incentives to redeem.
- May be callable at the initiative of the issuer only after a minimum of five years: (a) To exercise a call option an institution must receive the prior approval of the Superintendent; and (b) An institution's actions and the terms of the instrument must not create an expectation that the call will be exercised; and (c) An institution must not exercise the call unless: (i) it replaces the called instrument with capital of the same or better quality, including through an increase in retained earnings, and the replacement of this capital is done at conditions which are sustainable for the income capacity of the institution; or (ii) the institution demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.
- Any repayment of principal (e.g. through repurchase or redemption) must require Superintendent approval and institutions should not assume or create market expectations that such approval will be given.
- Dividend/coupon discretion: (a) the institution must have full discretion at all times to cancel distributions/payments; (b) cancellation of discretionary payments must not be an event of default or credit event; (c) institutions must have full access to cancelled payments to meet obligations as they fall due; and (d) cancellation of distributions/payments must not impose restrictions on the institution except in relation to distributions to common shareholders.
- Dividends/coupons must be paid out of distributable items.
- The instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the institution or organization's credit standing.
- The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law.
- Other than preferred shares and instruments classified, at issuance, as equity for accounting purposes (or instruments generally classified as equity at issuance), instruments must have principal loss absorption through a full and permanent conversion to common shares at an objective pre-specified trigger point equal to at least 5.125% Common Equity Tier 1. The conversion will have the following effects: (a) reduce the claim of the instrument in liquidation; (b) reduce the amount re-paid when a call is exercised; and (c) fully reduce coupon/dividend payments on the instrument.
- Neither the institution nor a related party over which the institution exercises control or significant influence can have purchased the instrument, nor can the institution directly or indirectly have funded the purchase of the instrument.
- The instruments cannot have any features that hinder recapitalization, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame.
- If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g. a special purpose vehicle – SPV), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Additional Tier 1 capital. For greater certainty, the only assets the SPV may hold are intercompany instruments issued by the institution or a related entity with terms and conditions that meet or exceed the Additional Tier 1 criteria. Put differently, instruments issued to the SPV have to fully meet or exceed all of the eligibility criteria for Additional Tier 1 capital as if the SPV itself was an end investor – i.e. the institution cannot issue a lower quality capital or senior debt instrument to an SPV and have the SPV issue higher quality capital instruments to third-party investors so as to receive recognition as Additional Tier 1 capital.
- The contractual terms and conditions of the instrument must include a clause requiring the full and permanent conversion of the instrument into common shares at the point of non-viability as described under OSFI's non-viability contingent capital (NVCC) requirements. Where an instrument is issued by an SPV, the conversion of instruments issued by the SPV to end investors should mirror the conversion of the capital issued by the institution to the SPV.
- Issued and paid-in in cash, or with the prior approval of the Superintendent, in property.
- Subordinated to depositors and/or general creditors of the institution.
- Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis the institution's depositors and/or general creditors.
- Maturity: (a) Minimum original maturity of at least five years; (b) Recognition in regulatory capital in the remaining five years before maturity will be amortized on a straight-line basis; and (c) there are no step-ups or other incentives to redeem.
- May be callable at the initiative of the issuer only after a minimum of five years: (a) To exercise a call option an institution must receive the prior approval of the Superintendent; and (b) An institution must not do anything which creates an expectation that the call be exercised; and (c) An institution must not exercise the call unless: (i) It replaces the called instrument with capital of the same or better quality, including through an increase in retained earnings, and the replacement of this capital is done at conditions which are sustainable for the income capacity of the institution; or (ii) the institution demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.
- The investor must have no rights to accelerate the repayment of future scheduled principal or interest payments, except in bankruptcy, insolvency, wind-up, or liquidation.
- The instrument cannot have a credit sensitive dividend feature; that is, a dividend or coupon that is reset periodically based in whole or in part on the institution or organizations' credit standing.
- Neither the institution nor a related party over which the institution exercises control or significant influence can have purchased the instrument, nor can the institution directly or indirectly have funded the purchase of the instrument.
- If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g. a special purpose vehicle –SPV), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Tier 2 capital. For greater certainty, the only assets the SPV may hold are intercompany instruments issued by the institution or a related entity with terms and conditions that meet or exceed the above Tier 2 criteria. Put differently, instruments issued to the SPV have to fully meet or exceed all of the eligibility criteria for Tier 2 capital as if the SPV itself was an end investor – i.e. the institution cannot issue a senior debt instrument to an SPV and have the SPV issue higher quality capital instruments to third party investors so as to receive recognition as Tier 2 capital.
- The contractual terms and conditions of the instrument must include a clause requiring the full and permanent conversion of the instrument into common shares at the point of non-viability as described under OSFI's non-viability contingent capital (NVCC) requirements. Where an instrument is issued by an SPV according to criterion #9 above, the conversion of instruments issued by the SPV to end investors should mirror the conversion of the capital issued by the institution to the SPV.
The Guideline provides that, effective January 1, 2013, all non-common Tier 1 and Tier 2 capital instruments issued by institutions must comply with the following principles to satisfy the NVCC requirement:
Principle #1: Non-common Tier 1 and Tier 2 capital instruments must have, in their contractual terms and conditions, a clause requiring a full and permanent conversion into common shares of the institution upon a trigger event. As such, the terms of non-common capital instruments must not provide for any residual claims that are senior to common equity following a trigger event. OSFI will consider and permit the inclusion of NVCC instruments with alternative mechanisms, including conversions into shares of a parent firm or affiliate, on a case-by-case basis.
Principle #2: All NVCC instruments must also meet all other criteria for inclusion under their respective tiers as specified in Basel III. For certainty, the classification of an instrument as either Additional Tier 1 capital or Tier 2 capital will depend on the terms and conditions of the NVCC instrument in the absence of a trigger event.
Principle #3: The contractual terms of all Additional Tier 1 and Tier 2 capital instruments must, at a minimum, include the following trigger events:
- 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
- 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.
The term "equivalent support" in the above second trigger constitutes support for a non-viable institution that enhances the institution's risk-based capital ratios or is funding that is provided on terms other than normal terms and conditions. For greater certainty, and without limitation, equivalent support does not include: (i) Emergency Liquidity Assistance provided by the Bank of Canada at or above the Bank Rate; (ii) open bank liquidity assistance provided by Canada Deposit Insurance Corporation (CDIC) at or above its cost of funds; and (iii) support, including conditional, limited guarantees, provided by CDIC to facilitate a transaction, including an acquisition or amalgamation.
In addition, shares of an acquiring institution paid as non-cash consideration to CDIC in connection with a purchase of a bridge institution would not constitute equivalent support triggering the NVCC instruments of the acquirer as the acquirer would be a viable financial institution.
Principle #4: The conversion terms of new NVCC instruments must reference the market value of common equity on or before the date of the trigger event. The conversion method must also include a limit or cap on the number of shares issued upon a trigger event.
Principle #5: The conversion method should take into account the hierarchy of claims in liquidation and result in the significant dilution of pre-existing common shareholders. More specifically, the 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 than those provided to pre-existing common shareholders.
Principle #6: The issuing institution must ensure that, to the extent that it is within the institution's control, there are no impediments to the conversion so that conversion will be automatic and immediate. Without limiting the generality of the foregoing, this includes the following:
- the institution's by-laws or other relevant constating documents must permit the issuance of common shares upon conversion without the prior approval of existing capital providers;
- the institution's by-laws or other relevant constating documents must permit the requisite number of shares to be issued upon conversion;
- the terms and conditions of any other agreement must not provide for the prior consent of the parties in respect of the conversion;
- the terms and conditions of capital instruments must not impede conversion; and
- if applicable, the institution has obtained all prior authorization, including regulatory approvals and listing requirements, to issue the common shares arising upon conversion.
Principle #7: The terms and conditions of the non-common capital instruments must specify that conversion does not constitute an event of default under that instrument. Further, the issuing institution must take all commercially reasonable efforts to ensure that conversion is not an event of default or credit event under any other agreement entered into by the institution, directly or indirectly, on or after the date of the OSFI Advisory from August 7, 2012, including senior debt agreements and derivative contracts.
Principle #8: The terms of the NVCC instrument should include provisions to address NVCC investors that are prohibited, pursuant to the legislation governing the institution, from acquiring common shares in the institution upon a trigger event. Such mechanisms should allow such 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 that is permitted to own shares in the institution and allow such transferee to thereafter receive direct share ownership.
Principle # 9: For institutions, including Schedule II banks, that are subsidiaries of foreign financial institutions that are subject to Basel III capital adequacy requirements, any NVCC issued by the institution must be convertible into common shares of the institution or, subject to the prior consent of OSFI, convertible into common shares of the institution's parent or affiliate. In addition, the trigger events in a institution's NVCC instruments must not include triggers that are at the discretion of a foreign regulator or are based upon events applicable to an affiliate (such as an event in the home jurisdiction of a institution's parent).
Principle #10: For institutions that have subsidiaries in foreign jurisdictions that are subject to the Basel III capital adequacy requirements, the institution may, to the extent permitted by the Basel III rules, include the NVCC issued by foreign subsidiaries in the institution's consolidated regulatory capital provided that such foreign subsidiary's NVCC complies with the NVCC requirements according to the rules of its host jurisdiction. NVCC instruments issued by foreign subsidiaries must, in their contractual terms, include triggers that are equivalent to the triggers specified in Principle #3 above. OSFI will only activate such triggers in respect of a foreign subsidiary after consultation with the host authority where 1) the subsidiary is non-viable as determined by the host authority and 2) the parent institution 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. This treatment is required irrespective of whether the host jurisdiction has implemented the NVCC requirements on a contractual basis or on a statutory basis.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.