What Happens in a Failure

Example of bail-in conversion

Stylized example – Effect of bail-in conversion on the balance sheet

The conversion of a failing D-SIB’s bail-in debt into common shares would be reflected in its balance sheet.

This example contains a diagram depicting the balance sheet of a hypothetical D-SIB to illustrate the effect of a bail-in conversion. This diagram has been simplified to illustrate the effect of the bail-in conversion only and it does not capture the full range of liabilities held on typical balance sheets of D-SIBs. 

The following analysis is based on a hypothetical D-SIB, ABC Bank, which enters resolution following its failure. CDIC assumes temporary ownership of the D-SIB1 and bail-in conversion is used.

Stage 1 – Business as Usual 

ABC Bank’s balance sheet in business as usual is presented in the first column in the diagram below.

Stage 2 – Heightened Risk (Severe Economic Downturn – ABC Bank records losses)

A severe economic downturn causes some assets from ABC Bank to come under particular stress and as a result, ABC Bank records a loss on its assets. This is shown in the second column in the diagram below.

Stages 3 to 5 – Point of Non-Viability to Stabilization/Restructuring

ABC Bank suffers a loss in market confidence. The Superintendent of Financial Institutions determines that ABC Bank has ceased or is about to cease to be viable. It is determined by the Governor-in-Council that CDIC should take temporary ownership2 of ABC Bank, which involves the following steps3 :

  • By operation of law, all of the common shares (equity) of ABC Bank are automatically transferred to CDIC4 and the pre-existing common shareholders no longer own their common shares or have any rights or entitlement to the shares. They are the first to suffer losses, in keeping with the creditor hierarchy.
  • Immediately after CDIC takes temporary ownership, the Superintendent of Financial Institutions announces that the conditions for conversion of any outstanding NVCC instruments have been met, triggering automatic conversion of all such instruments into new common shares in accordance with their contractual terms. This means that NVCC subordinated debt and NVCC preferred shares are written down to zero and common equity is increased by an equivalent amount. This absorbs a portion of ABC Bank’s losses, in keeping with the creditor hierarchy where preferred shareholders and subordinated debtholders absorb losses only after common shareholders have been impacted.
  • In order to absorb the remaining losses, CDIC determines that a portion of the outstanding bail-in debt must be converted to common equity.5 This means that a portion of bail-in debt is written down to zero and equity is increased by an equivalent amount on the balance sheet. Senior unsecured (or bail-in) debtholders are the last to absorb losses, in keeping with the creditor hierarchy.
  • Liabilities that are not eligible for bail-in conversion, including deposits, remain unchanged as they are insulated from losses by the scope of the bail-in regime.

Following the conversion of NVCC instruments and bail-in debt, the result is a recapitalized balance sheet for ABC Bank. This is shown in the last column in the diagram below.

Illustration of Impact of Bail-in Conversion on Balance Sheet

Stage 1: pre-loss balance sheet, stage 2: losses diminish assets and equity, stage 3 to 5: convert NVCC and bail-in debt to equity

Footnotes:

  1. CDIC would assume temporary ownership of the D-SIB through a Share E-FIRP, meaning that the outstanding shares of pre-existing shareholders would be transferred to CDIC.
  2. CDIC would assume temporary ownership of the D-SIB through a Share E-FIRP.
  3. In an actual failure scenario, CDIC would be preparing a valuation of the balance sheet at the point of non-viability to determine the size of actual and expected future losses to ensure that sufficient liabilities are converted to equity. This example, however, makes the simplifying assumption that there are no additional losses to recognize upon entry into resolution. The purpose of the example is exclusively to demonstrate how the bail-in conversion power can absorb losses.
  4. These pre-existing common shares remain on the balance sheet; they are temporarily owned by CIDC for the duration of the resolution.
  5. In order to restore market confidence, CDIC may choose to convert all of the D-SIBs bail-in debt, or an amount that results in a recapitalization that is greater than the loss. For simplicity, the converted amount of bail-in debt results in a recapitalization that is exactly equal to the loss amount in this example.

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