In the last few years, Canadian banks have been effectively sidelined from the preferred share and subordinated debt markets. The first half of 2014 has finally seen that market open again, with six Canadian banks completing preferred share offerings in the first five months of the year, and we expect to see more follow.
In January 2011, the Basel Committee released new requirements that all noncommon capital instruments issued on or after January 1, 2013 contain provisions that require them to be converted into common shares if the relevant regulator determines that the bank is no longer viable (thus the term non-viable contingent capital or NVCC). Capital instruments lacking NVCC features that were outstanding on January 1, 2013 no longer qualify as capital and must be phased out. It is estimated that as of October 31, 2013, the six largest banks in Canada had approximately C$50 billion of non-NVCC subordinated debt and preferred shares outstanding1, much of that issued in the wake of the financial crisis and now coming up on the five-year rate reset and redemption right of the banks.
What was once a $10 billion-per-year market—one that helped fund the banks' growth and allowed ongoing redemptions from time to time of outstanding subordinated debt and preferred shares—went dry as banks considered how to implement NVCC. There was no strong incentive for banks to rush to market with NVCC instruments as the phase-out rules for the existing non-NVCC instruments were relatively favourable and, under the new Basel III rules, common share equity has become the predominant form of capital in any event. As well, no bank was eager to be the first to release an offering as there was a general assumption that the first issuances of NVCC instruments might require a significantly higher coupon or interest rate to compensate investors for the risk of a triggering event conversion. Additionally, banks were hopeful that the Office of the Superintendent of Financial Institutions (OSFI) might reconsider its requirement that the NVCC conversion features be built into the terms of the instruments and move to a statutory regime utilized by other major jurisdictions, including the United States. In the end, OSFI maintained its position by requiring contractual NVCC.
2014: The First NVCC Preferred Shares
There were no NVCC offerings throughout 2013, the first year in which the new requirements were in force; the first Canadian bank did not jump back into the preferred share market until January 2014. Royal Bank of Canada (RBC) announced a C$200-million offering of NVCC rate reset preferred shares on January 21, 2014—a deal that was quickly upsized to C$500 million. RBC's deal paved the way for five more Canadian banks to access the preferred share market, as Toronto-Dominion Bank, Bank of Montreal, National Bank of Canada, Canadian Western Bank and Laurentian Bank raised a total of C$2.0 billion in the first five months of 2014 and RBC completed another C$500 million offering in late May. The offerings were well received by the market, evidenced by the upsizing of some of the deals after announcement, and the pricing of the deals generally, which were estimated to be only 10 to 30 basis points higher than the expected dividend rate on a similar non-NVCC instrument.
The NVCC Market Going Forward
The market is still waiting for the first offering of NVCC subordinated debt. There are a few reasons why the banks have remained hesitant to tap that market. One reason relates to changes in capital ratios mandated by Basel III, which reduce the need for subordinated debt on a bank's balance sheet. Prior to the introduction of Basel III, subordinated debt could account for almost one-third of the total capital of a bank. With the new minimum total capital requirement of 10.5%2 (including a countercyclical capital buffer of 2.5%) of risk-weighted assets and a 8.5% minimum for tier 1 capital, effectively the most that can be satisfied with subordinated debt is 2% of the bank's risk-weighted assets. As well, under Basel III, most deductions from capital must be made from common share equity, whereas in the past, certain deductions could be made from total capital. Effective January 1, 2015, the leverage or asset-to-capital ratio in Canada will be based on tier 1 capital as opposed to total capital. This requirement is particularly important for smaller deposit-taking institutions because they tend to be limited by their asset-to-capital multiples. As a result, we expect that subordinated debt will be eliminated from the capital structure of many smaller institutions—and will form a significantly smaller portion of the capital structure of larger institutions than it has historically.
Market uncertainty also remains over how the proposed "bail-in" debt regime will interact with NVCC instruments. In October 2011, the Financial Stability Board issued a paper providing that regulators should have the power to convert (or write off) all or part of the unsecured and uninsured creditor claims of a financial institution under resolution into equity or other ownership instruments. It was proposed that such a conversion would be done in a manner that respects the hierarchy of claims in liquidation. The 2013 Canadian federal government budget includes a proposed plan to implement a "bail-in" regime for systemically important banks3; Canadian banks and the market generally are still waiting for details as to how the federal government intends to implement this regime. The institutional investors that make up the vast majority of the market for subordinated debt are particularly concerned with how the bail-in regime will function and the effect of further dilution after NVCC instruments are converted, resulting in a "wait-and-see" approach to investor interest in NVCC subordinated debt offerings.
We expect that subordinated debt will be eliminated from the capital structure of many smaller institutions—and that it will play a much smaller role for larger institutions.
The precise conversion formula to be adopted by the banks for NVCC subordinated debt is not yet known. Under OSFI's requirements, conversion formulas for both NVCC preferred shares and subordinated debt need to be set to ensure respect for the relative hierarchy of claims between the two types of instruments in the event of a triggering event. In other words, since debt ranks ahead of equity in the traditional capital structure, in the event of a triggering event, holders of subordinated debt should receive more common shares on conversion than holders of preferred shares on a dollar-for-dollar basis. The banks have put substantial effort in the development of a formula used in the preferred share offerings which addresses concerns about potential market manipulation and death spirals in situations where conversion appears to be a possibility. As of the date this article was written, all offerings of NVCC preferred shares have used the same formula based on the issue price of the preferred shares, plus declared and unpaid dividends, divided by the volume- weighted average trading price over the 10 trading days before a triggering event, subject to a $5.00 floor price. It is unlikely that other banks will depart from this formula. The preferred share formula would suggest that the conversion formula for subordinated debt will use some multiple of the principal amount of the debt, together with accrued interest, to achieve the hierarchy of claims desired by OSFI. Issuers of NVCC subordinated debt should consider obtaining an advance income tax ruling from the Canada Revenue Agency confirming the deductibility by the bank of the interest payments, although we anticipate no difficulty in banks obtaining that ruling.
In the early days of NVCC offerings in Canada, Canadian banks have been content to stick to offerings of preferred shares. Although there has been a healthy appetite for the offerings so far, the market for these shares is principally Canadian retail investors. If the Canadian preferred share market is ultimately not large enough to fulfill the banks' capital needs, banks will need to turn to subordinated debt.
Canadian banks are also hopeful that an additional tier 1 capital instrument in which the distributions from the instruments could effectively be deducted for tax purposes by banks will eventually be available for issuance in Canada. Banks in other jurisdictions have access to this type of financing, which involves a hybrid debt instrument. Such instruments require careful structuring to achieve the desired tax, accounting and regulatory capital treatment.
1 Based on the financial statements of Toronto-Dominion Bank, Royal Bank of Canada, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce and National Bank of Canada for the financial year ended October 31, 2013.
2 An additional 1% surcharge will apply to the largest six banks, which were designated as domestic systemically important banks by Office of the Superintendent of Financial Institutions in March 2013. The surcharge will apply by January 1, 2016.
3 Supra, note 2.
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