BASEL III IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES

Transcription

1 INVESTMENTS & ADVICE BASEL III - IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES 1 INVESTMENTS & ADVICE BASEL III IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES The New Basel III rules will affect the eligibility and inclusion of non-common share instruments into a bank s regulatory capital. It also provides for a transition and phase out for instruments that do not meet the Basel III requirements. In order to qualify as Tier 1 capital under Basel III, after January 1, 2013, all non-common share instruments (i.e. subordinated debt, capital trust securities and preferred shares), must contain a provision that allows a financial institution to permanently convert these securities into common shares in the event that the institution is no longer viable. Capital instruments that contain this provision are now known as non-viability contingent capital ( NVCC ) and will be converted upon a trigger event. The objective of these additional Basel III provisions (NVCC requirement) is to ensure investors in non-common regulatory capital instruments fully absorb losses in a failed financial institution before taxpayers/governments are exposed. All non-common share instruments without the NVCC provision, also known as non-qualifying capital, will be phased out gradually from January 1, 2013 at 10% per year until 2022, after which they will no longer qualify as regulatory capital. With few exceptions, most subordinated debentures, capital trust securities and preferred shares will be affected by the new Basel III rules. In general, the likelihood of these securities being called on their first call date has risen substantially with most of these securities currently trading on a yield to call basis. HISTORY OF THE BASEL COMMITTEE AND ITS MEMBERSHIP The Basel Committee, established by the Central Bank Governors of the Group of Ten countries at the end of 1974, meets regularly four times a year. It has four main working groups, which also meet regularly. The Committee reports to the Central Bank Governors and Heads of Supervision of its member countries. One important objective of the Committee's work has been to close gaps in international supervisory coverage in pursuit of two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be adequate. To achieve this, the Committee has issued a long series of documents since In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord. This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by end Since 1988, this framework has been introduced to many countries with internationally active banks. Basel Committee Members Argentina Luxembourg Australia Mexico Belgium Netherlands Brazil Russia Canada Saudi Arabia China Singapore France South Africa Germany Spain Hong Kong SAR Sweden India Switzerland Indonesia Turkey Italy United Kingdom Japan United States Korea

2 INVESTMENTS & ADVICE BASEL III - IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES 2 In June 1999, the Committee issued a proposal for a revised Capital Adequacy Framework. The proposed capital framework consists of three pillars: 1. Minimum capital requirements, seeks to refine the standardized rules set forth in the 1988 Accord 2. Supervisory review of an institution's internal assessment process and capital adequacy 3. Effective use of disclosure to strengthen market discipline as a complement to supervisory efforts Following extensive interaction with banks, industry groups and supervisory authorities that are not members of the Committee, a revised framework was issued in This text serves as a basis for national rule making and for banks to complete their preparations for the new framework's implementation. Over the past few years, the Committee has moved more aggressively to promote sound supervisory standards worldwide. In response to the financial crisis of 2008, the Committee and its oversight body, the Group of Governors and Heads of Supervision, have developed a reform program to address the lessons of the crisis, which delivers on the mandates for banking sector reforms established by the G20 at their 2009 Pittsburgh summit. Collectively, the new global standards to address both firm-specific and systemic risks have been referred to as "Basel III".

3 INVESTMENTS & ADVICE BASEL III - IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES 3 BASEL III - WHAT ARE THE RULES? WHAT ARE THEY MEANT TO ADDRESS? Following the financial crisis of 2008, many types of non-common Tier 1 and Tier 2 capital (i.e. capital other than common equity) were criticized for failing to adequately absorb losses. Many foreign banks would have failed in the absence of government support. As a result, on February 4 th, 2011 the Canadian regulator, the Office of Superintendent of Financial Institutions (OSFI), decided to adopt the Basel III capital rules in Canada. What Constitutes Capital? Basel III provides a new definition of capital, a key element of which is the greater focus on common equity (the highest form of loss absorbing capital). Basel III Main Objectives To strengthen global capital and liquidity regulations with the goal of promoting a more resilient bank sector To improve the banking sector s ability to absorb shocks arising from financial or economic stress, which, in turn will protect the public/taxpayers from paying for bailouts of failing banks before investors fully absorb bank losses Rankings of Canadian Bank's Corporate Liabilities Highest Senior Debentures ( BA s, BDN s, Deposits Notes, GICs, PPN s, Step-up Notes) Tier 2 Capital Subordinated Debentures, Fixed-Floater bonds, Fixed rate bonds & Variable- rate bonds Lowest Tier 1 Capital Capital Trust Securities, Preferred Shares, Common Shares Effective January 1, 2013, all non-common share regulatory capital (i.e. subordinated debt, capital trust securities and preferred shares), must contain a clause that allows the financial institution to permanently convert these securities into common shares in the event that the institution is no longer viable. Capital instruments that contain these provisions are now known as non-viability contingent capital ( NVCC ) and will be converted upon a trigger event. A trigger event would include the following (1) the office Superintendent of Financial Institutions publicly announcing that the financial institution will cease to be viable without a write off or conversion (2) a federal or provincial government publicly announcing that the financial institution has accepted or agreed to accept a capital injection.

4 INVESTMENTS & ADVICE BASEL III - IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES 4 REDEFINING COMPONENTS OF CAPITAL UNDER BASEL III Under Basel III, Instruments qualifying for recognition as Tier 1 or Tier 2 capital will be restricted substantially. Distinction between upper Tier 2 and lower Tier 2 will be eliminated and Tier 3 capital will also be eliminated. In order to qualify, new non-common equity Tier 1 and Tier 2 instruments must: 1. Not contain incentives to redeem prior to their stated maturity 2. Be written off or converted to equity at the determination by the relevant supervisor either that the bank would not be viable without the write-off or without a public sector injection of capital. Tier 1 Capital (Common Equity, Preferred Shares & Capital Trust Securities) Tier 1 capital will need to be subordinated to depositors and general creditors, have fully discretionary non-cumulative dividends or coupons and have neither a maturity date nor an incentive to redeem. Common shares and non-cumulative perpetual preferred shares, which can be converted to common equity in the event of non-viability, will be compliant with the new rules. Tier 2 Capital (Subordinated Debentures, Fixed-Floater bonds) Tier 2 capital will be simplified there will be only one set of Tier 2 capital (rather than Tier 2A and Tier 2B under the current rules). Tier 2 capital will need to meet the minimum standard of being subordinated to depositors and general creditors and have an original maturity of at least five years. Subordinated debt issuances will not be compliant where they contain a step-up feature, other incentives to redeem, or provide for redemption in the first five years. Phasing Out Existing Capital Instruments The OSFI changes render ineligible a wide range of outstanding upper Tier 1 and Tier 2 instruments. Ineligible instruments (e.g. subordinated debt, capital trust issues and preferred shares), will be phased out gradually from Jan 1, In brief, their capital treatment will be amortized at 10% a year, hence in 2013 a financial institution will only be able to recognize 90% of the ineligible capital as qualifying capital, in 2014 only 80%, all the way until 2021 where they will receive just 10%, and nothing thereafter. Phase Out Arrangements for Capital Instruments No Longer Qualifying as Non-Common Equity (Dates as of January 1) Year % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

5 INVESTMENTS & ADVICE BASEL III - IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES 5 Raising Capital Requirements Basel III also raises the levels of capital requirements for banks. The minimum requirement for common equity, the highest form of loss-absorbing capital, will be raised from its current level of 2% to 4.5%. The level of Tier 1 capital (which includes common equity and other qualifying financial instruments whose inclusion will be based on stricter criteria) will increase from 4% to 6%. These new requirements are expected to be phased in over a period of five years beginning in Target Capital Ratios for Financial Institutions under Basel III (by 1/1/2018) Source: OSFI-BSIF Common Equity (after deductions) Tier 1 capital Total capital Minimum 4.50% 6% 8% Capital conservation buffer 2.50% 2.50% 2.50% Minimum plus conservation buffer 7.00% 8.50% 10.50% Countercyclical capital buffer 0% - 2.5% 0% - 2.5% 0% - 2.5% Upper end of Minimum capital 9.50% 11% 13%

6 INVESTMENTS & ADVICE BASEL III - IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES 6 IMPLICATIONS FOR CANADIAN INVESTORS With few exceptions, most subordinated debentures, capital trust securities and preferred shares have been affected by the new rules. In general, the likelihood of these securities being called on their first call date has risen substantially with most securities currently trading on a yield-to-call basis. Straight Perpetual Preferred Shares Following clarification surrounding Basel III guidelines perpetual preferred shares have been trading in two distinct units depending on eligibility as Tier 1 capital. The perpetual preferred issues that are not convertible in common shares (non qualifying) have started trading based on being redeemed prior 2022 while the remaining perpetual shares are trading based on a longer duration. Additionally, other factors including market conditions, the level of interest rates and the firm s maturity schedule will affect when and if the banks will redeem their non- qualifying perpetuals. Canadian Imperial Bank Of Commerce (CIBC) has also begun to redeem some of its non-viable contingent capital (NVCC) including its Series 30 perpetual (CM.PR.H) at a price of $25.75, Series 31 (CM.PR.I) at a price of $26.00 on January 21, 2012 and (CM.PR.J) series 32 on April 30, 2012 at a price is $26.00 per Series 32 share. The Bank of Montreal (BMO) has also redeemed its US $ Series 10 (BMO.PR.V) preferred shares at $25 on February 25, CIBC has also recently sought and received permission from OSFI to treat its convertible/soft redeemable Series 26 (CM.PR.D), Series 27 (CM.PR.E) and Series 29 (CM.PR.G) as NVCC (Non Viable Contingent Capital). Permission was granted on the basis that CIBC would relinquish its rights to convert the preferred shares into common for any reason other than the occurrence of a trigger event. Rate Resets Preferred Shares Due to higher reset rates on the older issues, we expect a high likelihood that these preferred shares will be called on their first call date as it is more advantageous for the banks to refinance at lower rates. Conversely, newer rate reset preferred shares with lower reset spreads could be extended past their first call date. The decision to call these shares depends on the banks relative funding costs and capital needs at the reset date, but for the most part, we currently expect that all outstanding bank rate reset preferred shares will be called on their first call date. Capital Trust Securities All outstanding Innovative Capital Trust Securities in their current form will not fully qualify as Tier 1 capital starting in Therefore, it is expected that they will be called on their first call date as originally envisioned when issued. Some of the more recent Capital Trust issues do contain clauses that allow banks to call these issues at par due to a regulatory change, which has indeed occurred. However, for those issues with a first non- regulatory call at par before 2023, OSFI has guided that the banks not call these securities based on the regulatory call. We assume OSFI would not allow the banks to call them should they move to do so. The two exceptions are the CIBC Capital Trust 10.25% June 30 th, 2039 and the TD Capital Trust 10% June 30 th, Based on OSFI guidance, it is likely these issues will be called on December 31 st, 2022 and have been trading in accordance to this expectation. Looking ahead, Macquarie Bank Limited came to the market with a new hybrid capital issue that qualifies as Tier 1 capital under the new Basel III capital framework, which may provide a template for the structure of capital issues going forward.

7 INVESTMENTS & ADVICE BASEL III - IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES 7 Issued in US dollars, the security is being described as an exchangeable capital security (ECS). The ECS has an initial coupon of 10.25% to June 20, Thereafter, if not called, the coupon is reset at the then 5-year US Treasury yield plus 9.1%, and is callable by the company every six months thereafter at par. This structure is similar to the Canadian rate reset preferred shares. However, there are key differences including: 1. Interest payments are subject to payment tests, and subject to certain conditions, the ECS will be exchanged for a variable number of common shares on the first call date (at 95% of the average weighted price of the common shares over a specified time period). 2. The ECS may also be exchanged earlier on an acquisition event, when the Tier 1 capital ratio falls below 5.125%, or when the regulator determines the bank would become non-viable without an exchange or public sector injection of capital (or equivalent support). 3. The ECS is redeemable, subject to the regulator s approval, at the discretion of the Issuer in limited circumstances, including a change in law that has an impact on the tax or regulatory treatment of the ECS. Tier 2 - Fixed Floaters Most fixed floater bonds in their current form will not fully qualify as Tier 2 capital beyond Hence, it continues to be expected that these issues will be called on their first call date and not float. This is in line with previous expectations; hence, there has been little market impact on these securities specifically due to the regulatory change.

8 INVESTMENTS & ADVICE BASEL III - IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES 8 APPENDIX Bankers Acceptance A commercial draft (i.e., a written instruction to make payment) drawn by a borrower for payment on a specified date. A BA is guaranteed at maturity by the borrower s bank. As with T-bills, BAs are sold at a discount and mature at their face value, with the difference representing the return to the investor. BA s may be sold before maturity at prevailing market rates, generally offering a higher yield than Canada T-bills. Bearer Deposit Note They are negotiable, short-term non-interest bearing notes issued by Banks. Bearer Deposit Notes are sold in bearer form at a discount to their face value. The difference between purchase price and redemption or maturity value is the investor s return. There is typically a secondary market which allows investors to sell their notes at prevailing market levels, prior to maturity. Term Deposits Term Deposits (TDs) are secure investments that can generally offer a higher rate of interest than a simple savings account. Term Deposits are offered in a number of currencies, and a wide range of terms, giving you the flexibility to choose one that best suits your short or long-term investment goals. Early redemption varies depending on currency. Guaranteed Investment Certificates (GICs) Guaranteed Investment Certificates offer fixed rates of interest for a specific term (longer than with a term deposit). Both principal and interest payments are guaranteed. They can be redeemable or non-redeemable. Non-redeemable GICs cannot be cashed before maturity, except in the event of the depositor s death or extreme financial hardship. Interest rates on redeemable GICs are lower than standard GICs of the same term, since they can be cashed before maturity. Recently, banks have been customizing their GICs to provide investors with more choice. Principal Protected Notes (PPNs) Principal Protected Notes (PPNs) are innovative financial products that combine key investment characteristics of both stocks and conventional bonds. The distinguishing feature of these investments is that the principal amount - your original investment - is 100% protected as long as the PPN is held to maturity. PPNs are available with a wide variety of underlying assets such as (stocks, mutual funds, indices, commodities, currencies and interest rates), terms and features. Extendible Step-up Deposit Notes They offer an alternative to conventional fixed income products. The investor in the Notes will receive a predetermined, fixed coupon that increases periodically over time. The issuer has the right, but not the obligation, to redeem the Notes early at par ($100) on specific dates during the lifetime of the Notes. Components of Tier 2 Capital Subordinated Debentures Subordinated debentures are junior to other securities issued by the company or other debts assumed by the company. They typically have a higher rate of return than senior debt due to the increased inherent risk and are usually accompanied with a lower credit rating than senior bonds. The exact status of an issue of subordinated debentures is described in the prospectus.

9 INVESTMENTS & ADVICE BASEL III - IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES 9 Fixed-Floater Bonds These are callable bonds issued by Canadian banks and insurance companies. They offer a fixed coupon up until their call date, which is usually five or 10 years prior to the date of maturity. If the bond is not called (at par), the issuer then pays a coupon based on a pre-specified spread over the floating banker's acceptance rate. Fixed-Rate Bonds A fixed rate bond offers you a guaranteed interest payment over a set period of time. With a fixed rate bond you know exactly how much you will earn in interest income over the life of the bond. Once you make an investment in a fixed rate bond, you will continue to draw a steady and reliable payment for the life of the bond with no exceptions. Variable-Rate Bonds These bonds automatically adjust to changing interest rates. They can be issued with longer terms than more conventional issues. A longer-term note (typically up to 5 years) that pays a floating rate coupon that resets regularly (i.e. quarterly or monthly).floating rate is based on CDOR (an average of 8 dealers bankers acceptance bids) in Canada or LIBOR in the U.S. Investor usually receives a premium versus regular money market securities due to the longer term. Components of Tier 1 Capital Capital Trust Securities a type of investment sold to investors by a specifically created trust established and controlled by a financial institution (i.e. banks or other financial intermediaries). They are trust-originated securities that combine the features of both preferred shares and corporate bonds. Preferred Shares - Types & Features Preferred Shares represent equity ownership and therefore are, by definition, not debt securities. However, they are in most other ways more debt like than equity like when we consider their structure and how they are traded in the Canadian marketplace. Preferred shares have pre-determined dividend rates, and preferred shareholders have a prior claim on dividends ahead of common shareholders. The lower tax rate on dividend income is the primary advantage preferred shares have over other debt securities in Canada. Perpetual Rate Reset issues that pay a fixed dividend for the initial 5 years after which, if not called by the company, the dividend is reset for another 5 years at a predetermined yield pick-up (spread) over the then benchmark 5-year Government of Canada bond. For the purpose of our tables, we show this as the Reset Spread. Holders also have the right to instead accept a floating rate preferred (see below) where the dividend is reset ever quarter at predetermined spread over the benchmark 3-month Government of Canada Treasury Bill. These securities are perpetual, as there is no option for the older to put the issue back to the company for par value. Perpetual Fixed Floater issues that pay a fixed dividend for an initial period after which, if not called by the company, the dividend is reset for another 5 years at a minimum of 80% of the then benchmark 5-year Government of Canada bond. Holders also have the right to instead accept a floating rate preferred where the dividend is reset ever quarter at predetermined percentage of the Canadian Prime Rate. These securities are perpetual, as there is no option for the holder to put the issue back to the company for par value. Straight Perpetual issues that pay a fixed dividend in perpetuity. Almost all of these issues will have call features of some form that will allow the issuer to redeem on and after a specified date.

10 INVESTMENTS & ADVICE BASEL III - IMPLICATIONS FOR CANADIAN BANK DEBT SECURITIES 10 Perpetual Floating Rate issues that pay a dividend based on a short term rate, typically the Canadian Prime Rate. Some issues have a dividend that is fixed at a specified percentage of Prime, others have a ratcheting mechanism where the percentage of prime will adjust upward or downward depending on the underlying trading price (when the price is below par value, the dividend is ratcheted up, when above par, it is ratcheted down). Retractable issues that pay a fixed dividend until the issuer redeems, or the holder retracts or puts their shares back to the issuer. Redemption and Retraction dates are typically set at a minimum of 5 years after issue, and the initial redemption prices are often at a premium to par value. Redemption is often soft, in that the issuer can choose to pay the holder in shares instead of cash at their option. Synthetic preferred shares that are not issued by an operating entity, but by an investment trust or corporation with the guarantee derived from an underlying investment portfolio. Most have specified maturity dates when the underlying portfolio unwinds and payments made to preferred and capital shareholders. Common Share securities that represent ownership in a company. They carry voting privileges and are entitled to the receipt of dividends, if declared. The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. Richardson GMP Limited is a member of Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.