For the past few quarters, Canada's Big Six banks have been bombarded with questions as to why they're stuffing themselves with capital. Despite the constant inquiries, detailed answers have been hard to come by.
Now that the federal government has finally released new rules around "bail-in" debt and its proposed procedures for dealing with failed banks, we have a better idea of what the country's largest lenders are up to.
Late Friday, the finance department announced a public consultation on its "taxpayer protection and bank recapitalization regime." In line with other major countries, Canada has agreed to design a program that would protect taxpayers when private banks fail – i.e. prevent government bailouts – and investors have long awaited the proposed rules for bail-in debt, which can be converted to equity in a crisis. Unlike regular bonds, which rank higher than stocks in the queue to be paid should there be a bankruptcy, this type of debt can be converted into equity if the bank fails, erasing their seniority.
While that news was expected, the finance department also announced a proposal that will require the domestic "systemically important banks" – that is, the Big Six banks – to yet another capital requirement, known as the Higher Loss Absorbency.
Under Basel III rules, capital rules are focused on common equity buffers, and banks are required to hold enough common equity capital such that it amounts to 7 per cent of their risk-weighted assets.
Now the finance department wants the big banks to hold capital of all types – common equity, non-viability contingent capital and bail-in debt – such that it amounts to between 17 and 23 per cent of their risk-weighted assets.
National Bank Financial analyst Peter Routledge helps put these figures in perspective. Before the financial crisis, Canada's banks held total capital ratios of between 11 per cent and 13 per cent of their risk-weighted assets. Not only are these totals lower, the definition of capital was much more lenient – for instance banks could include their big investments in financial institutions such as Bank of Nova Scotia's stake in CI Financial Corp. – and the risk-weightings were calculated in a very different way.
Because of the changes to both sides of the equation, Mr. Routledge estimates that Canada's banks will eventually have to hold more than double the amount of capital they did prior to the financial crisis.
Now we know why the banks have talked about holding much more common equity capital than they are required to by the Office of the Superintendent of Financial Institutions, Canada's banking watchdog.
If this regime seems ludicrous and overly punitive, Mr. Routledge points out that there was an era in Canadian history when regulators required the banks and their investors to shoulder more losses in the event of any failures.
Between Confederation and the Great Depression, he noted, shareholders were subject to "double liability," such that if a bank went belly up, shareholders could not only lose their investments, but could also lose additional money to help pay back senior creditors (mainly depositors). This regime was eventually replaced by government-backed deposit insurance.
Another thing to keep in mind: the banks are making record profits, despite holding more capital. Even if they are frustrated – and if they are, they haven't let on – senior executives can't really complain, because Canadian bank stocks are still on a wild run.