Canadian Banks and Basel Rules

Posted on September 6, 2010 and updated March 23, 2018 in Life Insurance Canada News 5 min read
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Embedded contingent capital. This may sound to you like a term from another planet, but it is a concept which is slowly coming after our banks. The Basel Committee listened to Canadian wishes and considers implementing this new regulatory feature in order to help preserve the stability of the world’s banks. Federal Finance Minister Jim Flaherty is “pleased” Canada’s advice was taken into account.

The Basel Committee on Banking Supervision is an institution which unites the central banks governors of ten nations world-wide. It meets four times a year and discusses recommendations, guidelines and best practices that the member states and other states should implement in their individual regulatory frameworks. Their decisions do not have any direct power over each national market, but they are widely supported and adapted as unified implementations help ensure that multinational banks operate in a coherent environment.

The new rules have to do with the way the banks account for debt which they owe, Financial Times report. Up until now, debt (whether a loan or a bond) has been accounted for as a liability of the bank towards its creditors. The creditors are preferred to shareholders in that in case of bankruptcy, creditors are paid out before equity holders. Also, debt repayment is traditionally more systematic and the creditor can expect to get back the face value of the debt by the end of the lending term. This makes regular debt much less risky than equity and thus cheaper.

In the future, banks may be allowed to convert parts of their debt to equity in case of a financial crisis – hence the word “contingent”. Such a conversion will have to be triggered by the federal government and will allow a bank to increase its capital levels instantly. More capital will let the bank survive longer and hopefully all the way through to the end of the crisis. Embedded contingent capital is therefore capital that is embedded in the debt, is available to the bank at any time, and is contingent upon need and government permission.

What these proposed rules are hoping to achieve is – in addition to improved banking sector stability – greater scrutiny of investors and lenders over the bank’s performance and lending practices. Being exposed to greater risk, lenders will have a greater incentive to monitor their banks and will do a better job of it, the Basel Committee thinks.

But will this be so? LSM Insurance argues that greater incentives are a positive notion, but that they will hopefully be backed by legislation ensuring transparency of the banking operations so that there are tools for investors to actually observe their banks effectively. Plus, it is not like the investors are not interested in the well-being of their banks today. The change may add additional pairs of eyes interested in the matter, but the marginal benefit of more observers remains questionable.

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The major implication of these new regulations for the banks themselves will be their new ability to acquire financing in a way that is cheaper than equity but a little more expensive than regular (unconvertible) debt. This is because the lenders will face a small contingent risk of changing rights as we explained above.

Debt (in the form of loans and bonds) normally obliges the debtors to pay interest and/or a part of the principal in regular instalments – annuities – according to the agreed-upon payment schedule. The face value of the loan or bond is repaid at the end of the term to the lender. Equity, however, gives the shareholder a portion of ownership including voting and other rights, but it is at the company’s discretion to decide how big the dividends are in a given year, or if there are any at all. Also, equity shareholders cannot expect the value of their investment to be returned at the end of the term (as there is no end of the term for ordinary shares) and the only way they can recoup their money is to sell their share hold to somebody else.

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Therefore, if Canadian banks use this borrowing facility “of the third kind”, their weighted average cost of capital (WACC) will increase slightly. But for that price, they will have a safety handle in place that can be pulled in case of emergency. Of course, there must be a market and means of valuation for such an instrument, but the banks seem to have decided that it is going to be worth it. The reassuring factor is that this feature can only be applied upon government approval and is not at the discretion of the banks themselves.

According to Reuters, Canadian banks are feeling ready to adopt the new rules and from their current position continue their successful post-crisis growth. Many banks and analysts are predicting acquisitions and mergers both at home and abroad. Banks will want to increase their presence especially in the US and European markets.

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