It wasn't the sexiest of announcements, but on Wednesday Canadian Imperial Bank of Commerce set the standard for what contingent capital could look like in Canada.
To refresh your memory, contingent capital securities are debt instruments that convert to common equity when a bank claims non-viability (in other words, when the bank is on the verge of failing.) This form of capital got some attention during the Basel III talks last year, but any mention of it fizzled out shortly after.
Yet behind the scenes, the Office of the Superintendent of Financial Institutions has been campaigning to get Canadian banks to hold it. Moreover, CIBC has been working with the OSFI to see if three of its outstanding preferred share issues, with a face value of $881-million, could be treated as contingent capital.
The three issues are unique because they were created with the option to convert them to common shares at a five per cent discount to their market value. CIBC has never opted to do that because it would dilute current shareholders, but the key point was that the option was always there.
On Wednesday the OSFI sided with CIBC and allowed these securities to be treated as contingent capital, provided that CIBC publicly announced that the preferred shares would not be converted into common unless the bank was at death’s door.
The decision made a mark in Canada because it created a “straw man” of what a contingent capital issue should look like, said analyst Peter Routledge at National Bank Financial. Although some features could be changed for future issues, at least the banks have a prospectus and a framework to start with when drafting up any new securities.
The decision also makes it easier for the banks to reach the OSFI’s target capital goal of 10.5 per cent. Basel III requires the banks to hold seven per cent capital in tangible common equity, but OSFI wants an additional buffer.
The question now is whether or not investors would buy new issues of these instruments. Considering that people already hold the CIBC securities, the fear factor of the unknown isn't as strong. Moreover, most Canadian investors don’t expect the banks to fail, so they may be happy to pick up some extra risk premium in the off-chance that the bonds convert to common equity.
There is also an accounting issue to iron out. At the moment, IFRS accounting rules require banks to assume that any non-common instrument that converts to common shares must be included in earnings per share calculations as if they had been converted. That has a big impact during earnings season because EPS values would be harder to compare. CIBC was able to skirt around this issue with its outstanding securities, but no one knows if future issues would fall under the same rules.