Canada: Recent Developments Related To Capital Applicable To Federally Regulated Financial Institutions

Last Updated: February 6 2009

By Robert W. McDowell, Robert Elliott, Stephen B. Kerr, Koker Christensen, Kathleen E. Yoa, A. Wojtek Baraniak, Marvin Mikhail, Jared Gordon

There have been a number of recent changes and announcements relating to capital, primarily from the Office of the Superintendent of Financial Institutions (Canada) ("OSFI"). This Bulletin summarizes these developments.

These developments have come in the midst of a global financial and economic crisis. As a result of recent financial turmoil, Canadian financial institutions have suffered substantial losses and are seriously affected by the lack of liquidity in global markets. Nevertheless, Canadian financial institutions remain well capitalized and are weathering the storm better than many of their foreign counterparts. In this regard, it is noteworthy that the current targets for risk-based Tier 1 capital and total capital ratios have not increased and, based on recent comments made by the Superintendent of Financial Institutions (Canada) (the "Superintendent"), it appears that OSFI does not intend to increase them. Most recently, echoing comments from their counterparts at the World Economic Forum in Davos, Finance Minister Flaherty and Bank of Canada Governor Mark Carney called on investors to ease the pressure they are putting on banks to hold capital rather than lending.

1. Budget 2009 – Proposed Power of Government to Inject Capital

Application: all federally regulated financial entities ("FREs")

In Budget 2009, the Minister of Finance announced the Government's intention to propose an authority that would allow the Government to inject capital into federally regulated financial institutions. Governments in other countries, most notably the United States and the United Kingdom, have recently invested heavily to keep their respective financial institutions secure and well funded and the Canadian Government has proposed powers that would enable it to take similar steps, should this prove necessary. While details of how this capital would be injected were not provided, according to the Budget this authority would only be exercised if the Minister of Finance determines, following consultations with the Superintendent, the Governor of the Bank of Canada and the Chair of the Canada Deposit Insurance Corporation ("CDIC"), that this would promote the stability of the financial system in Canada.

The Budget also indicated that the Government will propose that CDIC be given greater flexibility to enhance its ability to safeguard financial stability in Canada, including by giving CDIC the power to hold or own shares in its member institutions, subject to the approval of the Minister of Finance, where this would promote the stability of the financial system in Canada.

2. Advisories on Innovative Tier 1 Capital

Application: all FREs except for property and casualty insurance companies

In December 2008, OSFI finalized its Advisory on Innovative Tier 1 Instruments first issued in draft in June 2008. This Advisory provides that a new form of loan-based innovative instrument now qualifies for inclusion in Tier 1 capital. A special purpose vehicle ("SPV") would issue a 99-year security to investors and the SPV would use the proceeds from such issuance to acquire an inter-company debt instrument from the FRE with maturity conditions that match those of the publicly issued securities. To allow the FRE to maintain cash resources, the investors in the SPV securities would, in certain circumstances, receive directly issued preferred shares of the FRE to satisfy interest and/or principal payments on the innovative instrument. This Advisory also sets out enhanced disclosure requirements for qualifying asset-based and loan-based Tier 1 innovative instruments.

Also in December 2008, OSFI issued an updated Advisory on Innovative Tier 1 and Other Capital Clarifications – Revised Version. This is an update to the June 2007 version of this Advisory to reflect that trust preferred securities issued by an intermediate holding company are eligible for innovative Tier 1 capital treatment in the calculation of FREs' consolidated regulatory capital. These instruments previously qualified as Tier 2B capital.

3. Advisory on Enhancing Flexibility and Maintaining Capital Strength

Application: all FREs

On November 11, 2008, OSFI issued an Advisory on Enhancing Flexibility and Maintaining Capital Strength. This Advisory addresses two specific areas:

  • wholesale term borrowing insured by the Government's Canadian Lenders Assurance Facility ("CLAF"), or assets which benefit from equivalent guarantee or insurance programs operated by other governments, will now receive the same capital treatment as exposures to the governments providing the support; and
  • as an update to a January 2008 Advisory on Aggregate Limit on Tier 1-qualifying Preferred Shares and Innovative Instruments, the aggregate limit on Tier 1-qualifying preferred shares and innovative instruments included in Tier 1 capital was increased from 30% to 40%.

Of interest, we also note that Budget 2009 extended the deadline for issuing guaranteed instruments under the CLAF to December 31, 2009 and announced the establishment of a new Canadian Life Insurers Assurance Facility to guarantee wholesale term borrowings for life insurers, modelled on the CLAF.

4. Share Buy-Backs

Application: all banks and federally regulated life insurance companies

In a press release dated December 19, 2008, it was made clear that banks and federal life insurance companies are not to engage in share buy-backs without first clearing this with OSFI.

5. Revised MCCSR Guideline

Application: all federally regulated life insurance companies and fraternal benefit societies

As part of its ongoing review of capital requirements, on December 24, 2008, OSFI released a revised Minimum Continuing Capital and Surplus Requirements (MCCSR) Guideline which sets capital rules for the federally regulated life insurance industry.

The major changes that were introduced in the revised MCCSR Guideline are effective January 1, 2009 (unless indicated otherwise) and include:

  1. Section 1.1.3: The test for adequacy of assets for branches will now be measured on a tiered basis, consistent with that used for companies, and subject to the same minimum target ratios. The limit on other admitted assets for branches, which is similar to Tier 2 capital for companies, has been raised from 50% to 75% of the required margin.
  2. Section 1.1.3: Companies will now be required to maintain minimum Tier 1 capital (or available margin excluding other admitted assets) equal to 25% of MCCSR/TAAM required capital (or margin) calculated gross of all reinsurance ceded.
  3. Section 1.2.3: Collateral that is an obligation of the reinsurer or a related-party of the reinsurer may no longer be used to obtain credit in connection with unregistered reinsurance, and will be subject to the large exposure limits of the ceding company under Guideline B-2 (companies may delay implementation by contacting their Relationship Manager at OSFI.
  4. Section 2.1: The adjustments to available capital for accumulated unrealized gains and losses on available-for-sale debt securities have begun to be phased out.
  5. Section 2.1.4: Deductions that were formerly subtracted from total available capital will now be deducted 50% from Tier 1 and 50% from tier 2.
  6. Section 2.7: New offsets are now permitted from the negative reserve deduction from Tier 1 for policy capital components and other potential recoveries in the event of lapse. Additionally, cash surrender value deficiencies may no longer be aggregated across different product types.
  7. Section 2.12: Out-of-Canada terminal dividend reserves included in Tier 2C will now be tested for recoverability under stress scenarios.
  8. Section 3.1.1: The use of ratings on assets and issuers to derive the capital charge for C-1 risk will be subject to new requirements (companies may delay implementation until 2009 year-end).
  9. Section 3.2 and 3.3: Greater recognition of credit risk mitigation arrangements (collateral and guarantees) will now be permitted in certain circumstances.
  10. Section 4.1.1: New approximations have been implemented in the mortality component in cases where companies do not have seriatim data.
  11. Section 4.1.1 and 4.4.5: New formulas have been implemented to determine the credit for policyholder deposits and claims fluctuation reserves in the mortality and morbidity components (companies may delay implementation until 2009 year-end).
  12. Former Section 5: The capital requirements for interest margin pricing risk have been deleted.
  13. Chapter 7: The separate C-1 factors for derivatives counterparties have been deleted, and are replaced by the factors applicable to bonds.
  14. Chapter 9: A new component for foreign exchange risk has been introduced.

6. Advisory on Securitization – Expected Practices

Application: all FREs

OSFI issued an Advisory on Securitization – Expected Practices in final form in October 2008. There were no substantive changes to the draft Advisory released on June 19, 2008.

The Advisory provides, among other things, that:

  • the zero percent credit conversion factor for general market disruption liquidity facilities was eliminated and such facilities will now receive the same capital treatment as global style liquidity facilities; and
  • FREs are expected to ensure that short-term liquidity facilities (i.e. one year or less) are indeed short term exposures and, if not, FREs should be establishing higher capital charges to support such facilities.

7. Advisory on Segregated Fund Guarantee Capital

Application: all federally regulated life insurance companies

OSFI's Advisory on Alternative Method for Life Insurance Companies that Determine the Segregated Fund Guarantee Capital Requirement Using Prescribed Factors issued in December 2008 outlines an alternative factor-based method that may be used to determine the segregated fund guarantee capital requirement for life insurance companies.

Also in December 2008, OSFI issued an Advisory on Supplementary Information for Life Insurance Companies that Determine Segregated Fund Guarantee Capital Requirements Using an Approved Model which provides guidance to companies using the alternative method proposed by OSFI to calculate the segregated fund guarantee capital requirement specifically for year-end 2008 (subject to further review).

8. Advisory on Recognition of Hedge Contracts in Determining Segregated Fund Guarantee Capital Requirements

Application: all federally regulated life insurance companies

OSFI's December 2008 Advisory on Recognition of Hedge Contracts in the Determination of the Segregated Fund Guarantee Capital Requirement for Life Insurance Companies expands upon and clarifies OSFI's policy with respect to recognition of hedge contracts in the determination of the segregated fund guarantee regulatory capital requirement for life insurance companies.

9. Adjustments to Regulatory Capital Returns

Application: all FREs

On November 7, 2007, the Government announced proposed legislation to amend the Income Tax Act to adjust the calculation of taxable income for FREs so the calculation would be more consistent with the accounting of income under the fair value accounting changes ("mark-to-market tax law changes"). On November 28, 2008, the Government tabled a Notice of Ways and Means motion to give effect to the mark-to-market tax law changes. The amendments have not yet been enacted but the Canada Revenue Agency has advised FREs to file their tax returns as though the legislation had in fact been enacted.

As a result, since the effect of the mark-to-market tax law changes may not be reflected in financial statements and solvency tests filed with OSFI, there may be an understatement of regulatory capital. OSFI thus advised on December 24, 2008 that FREs may elect to file their regulatory capital returns incorporating the tax impact of the proposed mark-to-market tax law changes as though the changes had been substantively enacted. Regulatory financial statements should be filled in accordance with generally accepted accounting principles.

Looking Ahead

The Government and OSFI have been active in their review of capital-related issues. Clearly, conservative capital requirements have enabled Canadian financial institutions to maintain a relatively stable position when compared to their global counterparts. However, capital remains a live topic and it remains to be seen what other developments will arise.

For instance, procyclicality of capital has been identified by the Superintendent as an area requiring further study. Also, in December 2008, OSFI released its Discussion Paper on OSFI's Regulatory and Supervisory Approach to Reinsurance. This Discussion Paper addresses a number of issues related to capital for federally regulated insurers, including a review of OSFI's policy on using letters of credit as collateral in connection with unregistered insurance and minimum capital charges for life insurers to account for operational risk until a capital charge is formally developed.

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.

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