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Finance Minister Jim Flaherty said that consumer deposits would continue to be safe.

Adrian Wyld/The Canadian Press

Ottawa's plan to create a safety net for Canada's banks in the event of a financial crisis would involve a new kind of investment similar to bonds that will be sold to large institutional investors, rather than put the deposits of consumers at risk.

Sources familiar with the government's plan to create a "bail-in" mechanism for the financial sector, which will give banks access to emergency capital to keep themselves solvent in the event of a major crisis, say the concept is designed to prevent deposits or taxpayer money from being used to stabilize a bank.

Though the so-called bail-in structure has not been finalized, the concept has been in the works for more than two years and the government has been discussing the mechanics with the banks. A bail-in is when a bank turns to funds within its operations to stabilize itself, as opposed to a bail-out which draws upon outside sources, such as government money.

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The idea sparked controversy in recent weeks after the government mentioned in the federal budget that it would enact a bail-in regime in which a failing bank would use certain "liabilities" in order to stabilize itself.

Since deposits are one form of bank liability, that wording prompted immediate comparisons to the banking crisis in Cyprus, where the government ordered banks to draw upon the accounts of large depositors for emergency funds.

While the term "bail-in" has been used in both cases, Canadian officials are now scrambling to distance their plan from any that would use consumer deposits for capital. Amid questions about the plan, a spokeswoman for Finance Minister Jim Flaherty said in a statement that no consumer bank deposits – of any kind – would be drawn upon in the Canadian bail-in scenario.

"The 'bail-in' scenario described in the budget has nothing to do with consumer deposits and they are not part of the 'bail-in' regime," Department of Finance spokeswoman Kathleen Perchaluk said.

The statement came after Mr. Flaherty's office said earlier this week that consumer deposits would continue to be safe and are insured through the Canada Deposit Insurance Corp. (CDIC). However, that caused speculation that only those deposits up to $100,000, which are eligible for CDIC insurance, would be protected. Reports in certain newspapers and on Internet websites speculated that deposits above that threshold would be at risk if a bank was failing.

Without elaborating on the plan, the Finance Department said consumer deposits of any amount are shielded from the bail-in scenario.

Sources familiar with the plans say the Canadian bail-in scenario will rely on a specific class of new investments: subordinate bonds and deposit notes. The latter acts similar to bonds, where a large depositor such as an institutional investor or corporate customer with several hundred thousand dollars or more to deposit, buys a deposit note in order to get a slightly better return. It is similar to a contractual arrangement.

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Analysts, however, say it would take extreme circumstances for the concept of a bail-in to ever come into play.

These deposit notes and bonds are not financial products available to the average investor or depositor, and do not include funds held in consumer deposits.

"What they are doing is creating a new class of investor that's willing to accept the risk, but getting paid a bit more for it," said Peter Routledge, an analyst with National Bank Financial. "It's the investors who know they are taking the risk in advance, and got paid for it. Whereas you and I are fine."

The bail-in plan is in addition to measures the federal banking regulator put in place over a year ago that require banks to carry contingent capital, such as specialized bonds, on their books to act as a buffer against a crisis. Should a bank need capital, these would be quickly converted to shares, giving the bank capital.

"Under a 'bail-in' arrangement, a failing financial institution has to tap into its own special reserves or assets – which it has been forced to put aside – to keep its operations going," Ms. Perchaluk said. "The 'bail-in' regime would only kick in during the extremely unlikely event that a major bank in Canada begins to fail. This keeps the financial institution intact, without putting taxpayers at risk."

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