Banking is a confidence-sensitive industry, prone to periodic crises that sometimes require extraordinary support by governments. Thankfully, during the last crisis, Canada didn’t experience the same challenges as our neighbours to the south and across the Atlantic. However, privatizing a bank’s profits and socializing its losses is not a popular political position for a government to take.

An economic system requires a continuous supply of credit to function properly. Failures of smaller banks tend not to be disruptive to the system as a whole; however, a large-bank failure would be. Hence, Canadian bank regulators require higher minimum capital requirements for larger banks than for smaller ones—those designated as “systemically important.” In Canada, eight large financial institutions have this distinction: the Big Six banks, along with Caisse Desjardins, and Central 1 Credit Union.

The challenge for policymakers is in calibrating the appropriate amount of capital that a bank should hold. Too little capital leaves a system prone to crisis, whereas too much capital stifles lending by increasing banks’ cost base. Enter contingent capital, otherwise known as “CoCos”—securities that convert into loss-absorbing equity when a bank gets into trouble. If the losses incurred by a bank are larger than its equity can absorb, these securities convert into supplemental equity, providing additional loss-absorbing capability. In theory, a sufficient quantity of convertible securities will buffer any loss of deposits. There are two types of CoCos: high-trigger contingent capital (“HTCC”) and non-viability contingent capital (“NVCC”). The difference between HTCC and NVCC lies in the trigger itself.

Pulling the Triggers

HTCC’s trigger is typically based on an accounting metric, such as when a bank’s risk-based capital measure as defined by the regulator falls below some threshold. When the measure reaches the trigger point, the HTCC security automatically converts into equity, either through the issuance of common shares or through an increase in retained earnings by writing down the principal. This has the effect of not only adding additional loss-absorbing capacity to the bank but also decreasing its debt or leverage.

With an HTCC, conversion is triggered when a bank’s capital falls below a certain level but before it’s eliminated completely, and capital is injected before the bank fails. The trigger occurs prior to the point of non-viability (“PONV”), known as “going concern” capital. To date, European banks have been the primary issuers of HTCC.

HTCC has drawbacks. The conversion itself may erode confidence rather than contribute to it by signalling to markets that the bank is in trouble and needs equity. The conversion also inverts the hierarchy of claims as debt-holders suffer losses before shareholders. In addition, investors could game the trigger by shorting the stock of a bank close to its HTCC trigger and taking a long position in an HTCC security—essentially betting that regulatory capital will fall below the trigger. Should conversion occur, investors would close their short positions and profit from the subsequent rebound in the bank’s stock price.

In contrast, NVCC’s trigger is “gone concern” capital and is triggered when regulatory authorities declare the bank to be no longer viable, i.e., the bank has failed. Canadian regulators permit certain types of preferred shares and subordinated debt securities, known as innovative capital, into regulatory capital. Since January 1, 2013, all new innovative capital must have an NVCC conversion feature built into its terms. This approach is referred to as “contractual” contingent capital, as distinguished from the statutory approach taken in most other jurisdictions. At the time this article was written, all of the Big Six Canadian banks, save for The Bank of Nova Scotia, have issued NVCC-compliant securities.

New Rules for Canada

Canadian authorities have taken loss absorbency a step further. In August 2014, the Department of Finance issued a draft consultation paper on a bail-in regime for systemically important banks. They proposed a “higher loss absorbency” (“HLA”) requirement of between 17 percent and 23 percent of risk-weighted assets. This HLA would include regulatory capital (which contains common equity, NVCC-compliant preferred shares, and subordinated debt) and a bank’s senior unsecured debt. The senior unsecured debt would be converted on a pro-rata basis into common equity after losses exceed both common equity and the equity generated by the conversion of existing NVCC securities. Regulators would determine the specific amount of senior debt to convert based on the size of the bank’s losses.

This results in an additional $93 billion to $180 billion of contingent capital that could be tapped on top of the $150 billion in regulatory capital already held by the Big Six banks. The country’s largest lender, Royal Bank of Canada (“RBC”), would have to suffer an $86 billion loss before authorities would consider government support. That’s 23 percent of risk-weighted assets or roughly 10 percent of RBC’s asset base as of the third quarter of 2014.

There are drawbacks to contingent capital. It doesn’t protect a bank from a liquidity problem, nor has it been tested in a stress scenario, so it may behave in ways the regulator didn’t expect. In addition, calibrating minimum loss absorbency requirements to risk-weighted assets (calculations that often depend on normal distribution curves) may understate extreme “tail risks.” That said, it is a positive step forward in reducing the risk that taxpayers will have to support a bank during a crisis.