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Depositors’ money would not be used to stabilize a shaky bank in Canada. Instead, banks would be required to rely on their own capital set aside for a rainy day.DARRYL DYCK/The Canadian Press

The federal government is scrambling to clarify the language around its proposed "bail-in" scenario for Canadian banks in the event of a financial crisis, hoping to distance itself from the type of bail-in that occurred last week in debt-riddled Cyprus.

For the past two years Canadian regulators have used, without much controversy, the term "bail-in" to describe their proposed plan for stabilizing the sector in a crisis. However, when government officials in Cyprus ordered a bail-in of its banks last week that took a cut of customers' deposits, the term took on a much different meaning.

The Finance Department issued a clarification Tuesday explaining how a Canadian-style bail-in of the banks would work, should it be needed. The statement emphasized that depositors' money would not be used to help stabilize a shaky bank. Instead, Canadian banks must rely on their own capital, which they must set aside for a rainy day.

While that point was widely known within banking circles when regulators began drawing up the proposed new rules over the past few years, the situation in Cyprus sparked public scrutiny of this arcane issue. Over the weekend, news reports, blogs and Internet discussions began erroneously speculating that Canada's bail-in plan, which was mentioned in the recent federal budget, could target deposits here.

Some banks and government departments received phone calls from Canadians wondering if their deposits could be used in similar fashion, prompting the clarification from Finance on the differences between the two countries' proposals.

"The bail-in scenario described in the Budget has nothing to do with depositors' accounts and they will in no way be used here," Finance Minister Jim Flaherty's press secretary Kathleen Perchaluk said in a statement Tuesday. "Those accounts will continue to remain insured through the Canada Deposit Insurance Corporation, as always."

The confusion stems from the fact that a "bail-in" can take many forms. Typically, it refers to funds that a bank draws upon to stabilize itself in a crisis – funds that come from within the organization itself. And it differs from a bail-out, in which the bank receives emergency capital from an outside source, such as the government.

Canada began drawing up rules for a bail-in plan a few years ago in an attempt to avoid the large government bailouts required by some U.S. banks during the credit crisis. Under the proposed Canadian plan, banks would set aside contingent capital, such as shares, which could be quickly converted to cash to provide liquidity and stabilize their operations should a crisis hit.

Ms. Perchaluk said the Canadian structure involves capital the banks have been required to set aside, "without risking taxpayer money."

In Cyprus, depositors have been forced to take losses on uninsured deposits of more than €100,000 ($130,090). Depositors have surrendered 37.5 per cent of deposits over that threshold, which were then converted to equity in the bank. An additional 22.5 per cent of the funds have been held to use if further action is needed.

The moves caused Cypriots to pull their money from banks in droves to prevent it being lost to the bail-in.

Those developments in Cyprus sent ripples through the ranks of Canadian depositors after the federal government made reference to its own crisis-management scenario in the budget.

"The [Canadian] bail-in regime is to protect both taxpayers from having to bail out banks and depositors from having to take a financial hit like we've seen in Cyprus," Ms. Perchaluk said. "If a bank is having severe difficulties, the bail-in regime would force certain debt instruments to be converted into equity to recapitalize the bank."