What Happens in a Failure

How bail-in works

For further information on the bail-in tool and how it could be used, please follow the links below.

Rationale for the bail-in power

The 2008 global financial crisis highlighted that some banks are “systemically important” – that is, they are so important to the functioning of the financial system and economy that they cannot be wound down under a conventional bankruptcy and liquidation process without imposing unacceptable costs on the economy. These institutions are commonly labelled as “too-big-to-fail” (see International Context).

Faced with inadequate tools to deal with failed global banks, authorities in other jurisdictions were forced to rely on taxpayer-funded capital injections to support these banks in the interests of broader financial and economic stability. These are commonly referred to as “bail-outs”.

In addition to the direct costs to taxpayers associated with these bail-outs, the expectation of a bail-out if the bank were to fail gives the banks’ managers an incentive to take on excessive risk, as they would receive all of the potential benefits, but bear only some of the potential costs.

The expectation of a bail-out also allows domestic systemically important banks (D-SIBs) to borrow on more favourable terms, as creditors view the bank’s debt as implicitly guaranteed by taxpayers. By contrast, small and medium-sized banks do not benefit from this implicit subsidy in the form of lower funding costs, as there is less of an expectation that they would be bailed out should they fail.

In contrast to a bail-out, a “bail-in” is intended to rescue a failing bank by making its creditors and shareholders bear the cost of recapitalizing the bank through conversion of some or all of the bank’s bail-in debt into common shares.

The new bail-in power gives CDIC the authority to recapitalize D-SIBs from within, by converting some or all of a failing D-SIB’s bail-in debt into common shares in order to help restore it to viability.

The Canadian financial system remained resilient throughout the 2008 global financial crisis, with no Canadian bank failures. The strength of the Canadian financial sector should not be taken for granted, however, and the bail-in tool is a recommended international standard (see International Context) and gives CDIC another tool to address the risks posed by D-SIB.

Objectives of the bail-in regime

The objectives of the bail-in regime are to:

  • Preserve financial stability and minimize disruptions to the financial system;
  • Reduce taxpayer exposure; and
  • Increase market discipline and reduce incentives for D-SIBs to take excessive risk.

In the unlikely event of a failure of a D-SIB, the bail-in power would achieve those objectives by:

  • Restoring the D-SIB to viability;
  • Allowing the D-SIB to remain open and operating and to maintain the critical services it provides to its customers; and
  • Ensuring that D-SIB creditors and shareholders bear losses rather than taxpayers.

Use of the bail-in power

CDIC has a number of tools to assist or resolve a failing member institution. The specific tool used would depend on the circumstances of a particular situation.

The bail-in power provides CDIC with an additional tool to deal with the unlikely failure of a D-SIB. It builds on CDIC’s existing toolkit.

In the unlikely event of the non‑viability of a D-SIB, CDIC would use the tool that is most appropriate in the situation, taking into account its mandate and factors such as the cause of failure and the impact on the broader financial system.

International context

Canada has been an active participant in the G20’s financial sector reform agenda aimed at addressing the factors that contributed to the financial crisis. This includes international efforts to address the potential risks to the financial system and broader economy posed by institutions perceived as “too-big-to-fail”.

Following the global financial crisis that began in 2008, the Financial Stability Board (FSB) set out the responsibilities and powers that countries should have in place to resolve systemically important financial institutions, which are known as the Key Attributes of Effective Resolution Regimes for Financial Institutions (PDF, 830 KB) (Key Attributes). The objective of the Key Attributes is to make it possible for authorities to resolve a D-SIB in a manner that protects eligible deposits, maintains critical financial services, protects the economy, and minimizes risk to taxpayers. The Key Attributes were endorsed by Canada and other G20 countries in 2011.

Having the power to carry out a bail-in conversion within resolution is an important component of the Key Attributes.

A number of jurisdictions have already incorporated bail-in (or equivalent) powers into their own bank resolution regimes. Examples include the United States, Switzerland and all EU member states (including the United Kingdom) via the adoption of the European Union Bank Recovery and Resolution Directive (or BRRD).

The Canadian bail-in regime is broadly consistent with the international standards endorsed by the G20 and best practices of other jurisdictions.

The FSB also recently published a consultative document on principles to assist authorities in making the bail-in tool operational. The manner in which CDIC would implement a bail-in conversion is broadly consistent with these principles (see – Bail-in Tool Execution).

Bail-in framework – Key elements

The bail-in framework consists of a number of key elements:

  • Legislation: the CDIC Act provides CDIC with the legal power to effect a bail-in conversion.
  • Regulations: The bail-in regulations provide details on various aspects of the bail-in regime, including which instruments are subject to the bail-in power, factors that CDIC must consider in exercising the bail-in power, and the requirements that D-SIBs must follow when issuing the bail-in debt.
  • TLAC Guidance: D-SIBs need to have sufficient regulatory capital and bail-in debt that can be used in the event of a failure to absorb losses to withstand severe, but plausible, losses and be restored to viability. The TLAC (or Total Loss Absorbing Capacity) guidance sets, among other things, the minimum amount of total loss absorbing capacity that D-SIBs must have (see Bail-in Example).

Bail-in power

The CDIC Act provides CDIC with the legal power to undertake a bail-in conversion. In addition, the Bank Recapitalization (Bail-in) Conversion Regulations and the Bank Recapitalization (Bail-in) Issuance Regulations provide details on various aspects of the bail-in regime.1

CDIC has the power to undertake a bail-in conversion by converting specified debt of a failing D-SIB into common shares to recapitalize the D-SIB and allow it to remain open and operating.2 The CDIC Act provides CDIC with the flexibility to determine the amount of bail-in debt to be converted into common shares, as well as the timing of conversion, including whether the conversion will take place over a period of time, and in one or more steps.

The bail-in power cannot be used unless CDIC has taken temporary control or ownership of the D-SIB. Under the CDIC Act, CDIC can take temporary control of a bank in one of two ways: through ownership of the shares of a bank (through a Share FIRP); or control of the assets of a bank (through an Asset FIRP) to carry out a transaction in order to restructure a bank. These powers are known as Financial Institution Restructuring Powers (or FIRP).

CDIC’s powers were enhanced when the bail-in power was introduced, namely to allow for a longer period of CDIC ownership or control (one year with up to four one-year extensions, for a total of five years). These enhanced powers, referred to as E-FIRP (Enhanced Financial Institution Restructuring Powers), can only be used in respect of D-SIBs.3

CDIC temporary control or ownership of the D-SIBs is necessary as bail-in conversion would likely be accompanied by other steps to return the D-SIB to viability. These could include, for example, replacing the directors of the D-SIB, using the D-SIB’s existing employees and contractors to ensure the essential services of the D-SIB are maintained, and restructuring the D-SIB as necessary – for example, selling off troubled assets or subsidiaries. Through these powers, CDIC would also have the ability to impose losses on existing shareholders, either by having the shares transferred to CDIC or by diluting their ownership through a bail-in conversion.

Writing-down bail-in debt without providing common shares in exchange is not permitted under the bail-in power.

What is included?

The bail-in regulations set out which instruments are eligible for bail-in conversion. The bail-in power applies only to the following instruments:

  • Long-term (i.e., an original term to maturity of more than 400 days) unsecured senior debt that is tradable, transferable, and issued by D-SIBs.
    • Instruments are considered tradable and transferable if they have a Committee on Uniform Securities Identification Procedures (CUSIP) number, International Securities Identification Number (ISIN) or other similar identification.
  • Preferred shares and subordinated debt that are not NVCC will also be eligible for a bail-in conversion.
    • In practice, D-SIBs are not expected to issue any such instruments, as preferred shares and subordinated debt are almost exclusively issued by D-SIBs in the form of NVCC in order to count towards the regulatory capital requirements set by OSFI.

The bail-in power will not be retroactive. This means that only instruments that are issued, or amended to increase their principal value or extend their term to maturity, on or after September 23, 2018 will be eligible for bail-in conversion. The bail-in power will not apply to existing instruments that otherwise meet the above eligibility criteria.

What is excluded?

The following are not eligible for a bail-in conversion:

  • Deposits (including chequing accounts, savings accounts and term deposits such as GICs);
  • Secured liabilities (e.g., covered bonds);
  • Eligible financial contracts (e.g., derivatives); and
  • Most structured notes.4

While they are not subject to conversion under the bail-in regime, NVCC instruments are subject to conversion pursuant to their contractual terms and would fully convert into common shares prior to the bail-in conversion of senior debt into common shares.

Ability to impose losses on other instruments

As noted above, the bail-in regime does not apply retroactively. This means that capital instruments (that is, preferred shares and subordinated debt) that were issued prior to September 23, 2018 and that do not contain contractual conversion features, also referred to as NVCC,5 are not eligible for conversion under the bail-in regime.

However, these instruments could be subject to losses through the exercise of CDIC’s other resolution tools. Under the CDIC Act, CDIC has a variety of options available in terms of how to treat these instruments; CDIC could choose to wipe them out completely or treat them the same as equally-ranking NVCC instruments.

For example, in cases where a Share E-FIRP is used, legacy subordinated debt and legacy preferred shares could be transferred to CDIC by the Governor in Council, and CDIC could provide shares or cash to the original holders in return. In those circumstances, holders of these instruments could expect to:

  • bear losses before more senior instruments; and
  • receive equal or less favourable treatment than equally-ranking NVCC instruments.

This would result in senior bail-in debtholders being better off than holders of more junior-ranking instruments, which would respect the creditor hierarchy.

In a similar fashion, common shares outstanding prior to the D-SIB’s failure could also be transferred to CDIC by the Governor in Council. In such a case, the holders of these common shares would likely not receive anything in return, although they could be entitled to compensation.

Bail-in conversion

As described in the bail-in power section, the CDIC Act provides CDIC with the flexibility to determine the portion of bail-in debt to be converted into common shares, as well as the timing of conversion, including whether the conversion will take place over a period of time, and in one or more steps.

While CDIC has flexibility with respect to amount and timing of conversion, the bail-in regulations set out certain conversion parameters that CDIC must follow in determining the conversion terms for bail-in debt. These parameters are aimed at clarifying that the purpose of a bail-in conversion is to recapitalize the institution to a level that supports market confidence and ensure that relative creditor hierarchy is preserved.

CDIC must set the terms and conditions of a bail-in conversion in accordance with the following parameters:

  • Adequate recapitalization — in carrying out a bail-in, CDIC must take into consideration the requirement in the Bank Act for banks to maintain adequate capital.
    • The intent of this requirement is to ensure that the D-SIB emerges from the bail-in conversion appropriately recapitalized, with a buffer, in order to restore the D-SIB’s viability and market confidence.
  • Order of conversion — CDIC may only convert bail-in eligible instruments if all subordinate-ranking bail-in eligible and NVCC instruments have been converted.
  • Treatment of equally-ranking instruments — all equally-ranking bail-in eligible instruments must be converted in the same proportion (pro rata) and receive the same number of common shares per dollar of the claim that is converted.
    • Conversion is on a pro rata basis. This means that CDIC does not have the discretion to choose to convert certain debt by type of debtholder or location of debtholder. CDIC would also have to convert all of a D-SIB’s equally ranking bail-in debt at the same rate (i.e., CDIC could not convert 100% of a certain debt instrument and 50% of another equally-ranking instrument).
  • Relative creditor hierarchy — holders of bail-in eligible instruments must receive more common shares per dollar of their claims that is converted than holders of subordinate ranking bail-in eligible instruments and NVCC instruments that have been converted.
    • The bail-in power respects the relative creditor hierarchy, meaning that holders of more senior bail-in eligible instruments must be better off than holders of subordinate ranking bail-in eligible instruments and NVCC that have been converted. Therefore, the bail-in power does not change the hierarchy of claims, but rather provides a tool for ensuring that the losses that led to the failure of the D-SIB are borne by the investors of the D-SIB based on their creditor ranking.

The bail-in regulations do not include a fixed conversion rate setting out how many common shares bail-in debtholders would receive for each dollar of the debt that is converted. This provides CDIC with discretion to set appropriate conversion terms based on the circumstances at the time.

Issuance requirements

The bail-in regulations set out requirements that D-SIBs must follow when issuing bail-in eligible debt. The regulations seek to ensure that:

  • Investors have clarity on which debt is subject to the bail-in power. The bail-in regulations require D-SIBs to provide investors with a prospectus or other relevant offering or disclosure document, and to disclose to investors in that document that an instrument is eligible for bail-in conversion. The disclosure requirements set out in the bail-in regulations pertain only to the potential for a bail-in conversion; they are in addition to, and not in lieu of, any other disclosure requirements. In addition, the bail-in regulations prohibit D-SIBs from advertising or otherwise promoting bail-in debt as a deposit to purchasers in Canada, to ensure those investors can easily distinguish between debt that is eligible for the bail-in power and debt that is not.
  • CDIC’s bail-in power can be exercised in respect of all bail-in eligible instruments, even where instruments are governed by foreign law. The bail-in regulations require that instruments eligible for the bail-in power indicate in their contractual terms that the holder of the instrument is bound by the application of the
    CDIC Act, including the conversion of the instrument into common shares under the bail-in power. The bail-in regulations require that the provisions relating to bail-in conversion be governed by Canadian law, even where the rest of the contract is governed by foreign law. These provisions are important since Canadian D-SIBs issue significant amounts of debt outside of Canada.

D-SIB designation and Total Loss Absorbing Capacity (TLAC)

The Office of the Superintendent of Financial Institutions (OSFI) has identified Canada’s six largest banks as being D-SIBs, recognizing that the disorderly failure of these banks could have a detrimental impact on the functioning of the Canadian financial system and economy. In addition, the FSB designated Royal Bank of Canada (RBC) and the Toronto-Dominion Bank as global systemically important banks (G-SIBs).

To ensure D-SIBs have the capacity to withstand severe but plausible losses and emerge from a bail-in well-capitalized, the legislative framework of the bail-in regime includes a requirement in the Bank Act for Canada’s D-SIBs to maintain a minimum capacity to absorb losses, which is set and enforced by the Superintendent of Financial Institutions.

The Superintendent of Financial Institutions has issued orders to each D-SIB specifying the minimum amount of total loss absorbing capacity (TLAC) they must hold. More specifically, D-SIBs will be required to maintain a minimum risk-based TLAC ratio of at least 21.5% of risk-weighted assets and a minimum TLAC Leverage ratio of at least 6.75%, pursuant to orders issued to each D-SIB by the Superintendent. This requirement is broadly consistent with the FSB TLAC standard.6

OSFI’s TLAC guideline requires D-SIBs to reach the minimum TLAC amount by November 1, 2021. If a bail-in were to occur before a D-SIB had reached its minimum TLAC requirement, CDIC would be able to bail-in the amount of debt that is available. In addition, it would have other tools at its disposal that could be used to address any shortfalls.

Resolution stages

The resolution of a D-SIB would involve a number of key phases. Below is an illustrative timeline that details the various stages of a bail-in resolution, and the actions and events that might take place at each stage.7

  1. Business as Usual: during this period, the D-SIB is in good financial health.
  2. Heightened Risk: during this period, the D-SIB faces severe financial difficulties (potential lead up to resolution, if difficulties are not addressed).
    • During this stage, the D-SIB may implement recovery plan actions under OSFI’s oversight, while CDIC may monitor and undertake any necessary preparatory activities.8
    • There could be a general lack of market confidence in the D-SIB. The D-SIB could experience credit rating downgrades and challenges raising capital and/or funding.
  3. Point of Non-Viability: this is when the Superintendent of Financial Institutions determines that the D-SIB has ceased or is about to cease to be viable.
    • The Superintendent would form the opinion that the D-SIB is about to become or is no longer viable, after providing the D-SIB with an opportunity to make representations. This opinion would be provided by the Superintendent to the CDIC Board of Directors and would not be made public.
    • If the CDIC Board of Directors determined that the use of the bail-in power would be appropriate, it would make a request to the Minister of Finance outlining a proposed resolution approach, including the use of the bail-in power.
    • If the Minister of Finance were of the view that it is appropriate to do so, he or she would make the recommendation regarding a resolution approach to the Governor in Council (GIC) (i.e., the federal Cabinet).
    • If agreeable, the GIC would make an order (GIC order) authorizing CDIC to take temporary control or ownership of the non-viable D-SIB9 and directing CDIC to carry out a bail-in conversion to recapitalize the D-SIB.
  4. Resolution Weekend: this is the initial period during which CDIC would take temporary ownership or temporary control of the D-SIB, upon the GIC order being issued.
    • In most scenarios, CDIC expects that a GIC order would be issued after the markets close on a Friday, so that CDIC would take control or ownership of the D-SIB on the Friday evening.
    • It is expected that CDIC would make a public announcement to inform market participants and the general public that the D-SIB has entered resolution, that CDIC has temporary ownership or temporary control of the bank, and that the bail-in power will be used as part of the strategy to restore the D-SIB’s viability.
    • CDIC (and potentially other federal authorities) would take the actions necessary to ensure that the D-SIB can re-open and its operations can continue on the Monday morning. For example, depending on the circumstances, authorities may need to provide liquidity funding to the D-SIB until it restores its market funding channels.
    • Voting rights of existing and new common shares would be suspended until CDIC no longer controls or owns the D-SIB.
  5. Stabilization/Restructuring: During this stage, CDIC would undertake any necessary restructuring measures (e.g., selling off troubled assets or subsidiaries) to address the underlying cause of failure and return a viable D-SIB to the private sector. It is during this period that bail-in debt would be converted.

Bail-in Conversion

  • The CDIC Act provides CDIC with the flexibility to determine the portion of bail-in debt to be converted into common shares, as well as the timing of conversion, including whether the conversion will take place over a period of time, and in one or more steps.
    • For example, CDIC could choose to convert bail-in debt into common shares over the resolution weekend, or later during the stabilization period.
    • CDIC could also choose to convert bail-in debt into interim instruments, before subsequently converting the interim instruments into common shares.
  • CDIC would determine the amount of bail-in debt to be converted to restore the D-SIB’s capital levels to an adequate level with a buffer for market confidence and determine the number of shares that bail-in debtholders would receive in exchange for their debt.
  • Bail-in debt would be fully or partially converted into new common shares.

Other Restructuring Actions

  • A bail-in conversion would be used as part of a suite of measures to return the D-SIB to viability.
  • The restructuring actions taken during this stage would generally be in keeping with the D-SIB’s resolution plan, although they would also be substantially dependent on the circumstances facing the D-SIB at the time of resolution.
  • Depending on the circumstances, CDIC may choose to replace the D-SIB’s Board of Directors and senior management.
  • CDIC’s goal would be to return the D-SIB to private control as soon as possible, although the GIC may authorize CDIC to be in control for up to five years.
  1. Exit: After the completion of the bail-in conversion and other necessary restructuring measures, CDIC would return the D-SIB to private control.
    • Once the D-SIB is stabilized, it would be returned to the private sector.
    • Common shareholders would regain full control and voting rights.

For more information see:


Footnotes:

1 Please note that there were also amendments made to the CDIC Act to implement a new compensation regime for shareholders and creditors affected by CDIC’s actions to resolve a non-viable member institution. This is covered in a different section of the website.

2 CDIC must be directed by the Governor-in-Council (i.e., the federal Cabinet) to undertake a bail-in conversion.

3 CDIC could take temporary control or ownership of a D-SIB through E-FIRP for up to one year, with the ability for the Government to grant up to four extensions of one year each upon GIC approval, up to a maximum of five years. At the end of the five years, the D-SIB would be returned to the private sector.

4 Structured notes are debt obligations whose returns may be based on, among other things, equity indexes, a single equity security, a basket of equity securities, interest rates, commodities, and/or foreign currencies.

5 Since January 1, 2013, OSFI has required all non-common regulatory capital instruments (for example, subordinated debt and preferred shares) issued by banks to contain contractual terms (NVCC) that allow for the automatic conversion into common shares (or write down of the instrument) if the bank becomes non-viable.

6 TLAC, or Total Loss Absorbing Capacity, is a standard applicable to global systemically important banks. This standard was finalized by the Financial Stability Board in late 2015 and endorsed by the G20.

7 For the purposes of this backgrounder, we have assumed that immediately after CDIC takes control, the Superintendent of Financial Institutions would announce that the conditions for conversion of any NVCC instruments have been met, triggering automatic conversion of all such instruments into common shares in accordance with their contractual terms.

8 The coordination mechanism in place between OSFI and CDIC during the recovery stage is described in the Guide to Intervention for Federally Regulated Deposit-Taking Institutions.

9 CDIC control or ownership of the D-SIB through E-FIRP is a necessary precondition for the bail-in power to be used.

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