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The big risk Canadian bank investors aren’t considering

Bank buildings tower over the corner of Bay Street and Adelaide streets in Toronto.

Gloria Nieto/The Globe and Mail

Big Six bank investors barely blinked when Ottawa asked them to bear more risk during the next financial crisis. A startling new study suggests they shouldn't be so submissive.

To prevent taxpayers from being asked to bail out the country's banks, the federal government has proposed new rules that will force bank investors of all stripes – both bondholders and shareholders – to absorb any losses before public funds are put to work. The proposals are part of a global campaign to make private investors pay dearly in a bailout before taxpayers are asked to contribute.

Under the new regime, certain preferred shareholders and bank bondholders are subject to rules that allow regulators to convert their investments into common shares if financial institution they have invested in fails. Such a program is designed to quickly create more common equity, which is the best safety cushion a bank can have during a crisis.

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So far, few observers seem bothered by the new rules. Canada's banks have already raised billions of dollars worth of these new "bail-in" preferred shares and the same financial institutions are now selling the applicable bonds.

Until now, discussion of the new regime's rules has focused on the risks for buyers of these new securities. But after studying the proposals, National Bank Financial analyst Peter Routledge found that, under the new rules, commmon shareholders should be much more concerned, because they are quickly treated as collateral damage under the new regime. Should a new crisis emerge, common shareholders could be quickly wiped out, and that could rewrite the survival playbook.

Employing standard banking assumptions about leverage ratios and balance sheet sizes, Mr. Routledge discovered that just a 6 per cent drop in asset values, possibly from writing down a loan book and securities portfolio, would deplete a bank's common equity capital. Because the bank's existing common shareholders would then be wiped out, the preferred shareholders and bondholders would have their securities converted into common shares – making them the bank's new owners.

Under the old rules, governments tried their best to protect common shareholders by setting up bailout schemes such as the Troubled Asset Relief Program, which purchased preferred shares and took toxic debt off of bank balance sheets, but did not upend the common equity investor base.

Mr. Routledge worries too few people appreciate just how easy it is to wipe out the existing shareholders under the proposed rules. When people start to realize this, possibly during the next crisis, he fears it will have disastrous implications for troubled banks.

Mr. Routledge uses Canadian Imperial Bank of Commerce's most recent crisis experience to illustrate this point. A month after the bank disclosed its exposures to mortgage-backed securities in December 2007, CIBC issued $2.9-billion of common equity – much more than was required. Rather than raise the minimum it needed to survive, CIBC went all out, and that cushion ultimately helped to assure investors about the bank's health during the worst of the crisis.

Will Canadian investors be just as willing to step up the next time a bank is teetering – especially when they realize that under this new regime, they could quickly be wiped out? That's the billion dollar question.

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"If you are a Canadian [bank] CEO or board member, then you had better think ahead," Mr. Routledge wrote in a note to clients.

Mr. Routledge believes Canada's banks will starting carrying much more capital so that they aren't forced to stuff their cushions at the worst of times, when investors may balk. Currently, the average common-equity-to-capital ratio across Canada's Big Six banks is 9.8 per cent, and Mr. Routledge believes that will jump to 11 per cent.

Even if the banks do not want to raise more capital now, the federal finance department's new rules require them to do so. Under the proposal, the banks must meet a new High Loss Absorbency ratio, which includes three types of capital – common equity, non-viability contingent capital such as the preferred shares, and bail-in debt – of between 17 and 23 per cent of their risk-weighted assets. Although the banks can meet this target with whatever mix they see fit, Mr. Routledge believes they will choose to boost their common equity contributions by at least a little bit because it is viewed as the best form of capital in a crisis.

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