Bank failures around the world during the recent financial crisis put taxpayers on the hook for trillions of dollars in government backstopping. In future, requiring banks to issue contingent capital, which would convert from debt to equity when banks run into trouble, is one way to help avoid that happening again, and limit taxpayer costs if it does, according to this paper. The author makes the case for contingent capital, critiques the current federal proposal, and makes recommendations for design that would help stave off disaster for banks, not hasten their demise.Financial Services, bank failures, contingent capital, Office of the Superintendent of Financial Institutions (OSFT)

John F. Chant

English

Research Papers in Economics

e-brief
FINANCIAL SERVICES
Strengthening Bank Regulation: OSFI’s Contingent Capital Plan
E
S
S
E
N
T
I
A
L
 
P
O
L
I
C
Y
 
I
N
T
E
L
L
I
G
E
N
C
E
May 27, 2011
 Bank failures around the world during the recent financial crisis put taxpayers on
the hook for trillions of dollars in government back-stopping. Consequently,
governments have proposed a number of initiatives, including increases in the
level of capital banks must hold, to reduce the risk that the public will soon need
to rescue banks again. 
 One plan would see banks issuing contingent capital, debt instruments that
convert to equity when a bank runs into financial difficulties. Contingent capital
would replenish shortfalls in the institution’s core capital when it is most needed,
so that investors do the bailing out, not the taxpayer. Investors’ risk exposure
would drive them to monitor bank risk-taking more closely.
 Canada’s Office of the Superintendent of Financial Institutions (OSFI) has
released a draft proposal for implementation. While a welcome initiative,
technical improvements are needed. The trigger for conversion, for example,
should occur in stages, before banks get deep into financial difficulty.
 In addition, the terms of conversion – the amount of equity investors get in return
for the debt they hold – should expose the holders to market pressures. Debt
holders would be required to convert the debt into equity at a conversion ratio
set when the debt was issued. 
Governments of industrialized countries committed over $14 trillion in public funds – almost one-quarter of
global GDP – to support financial institutions during the financial crisis.
1 They had little choice in face of
uncertainties about the consequences of large, interconnected institutions failing. This experience makes it
clear that the time to repair a financial system is not in the midst of a crisis, and that the groundwork for
avoiding crises and mitigating them must be laid in advance. 
By
John F. Chant 
The author is an Emeritus Professor of Economics at Simon Fraser University and a member of the Task Force for
Payments System Review. He thanks Philippe Bergevin, James Fleming, Walter Engert, Clyde Goodlet, Finn Poschmann and
members of the Financial Services Research Initiative for their comments and suggestions.
1 See Allesandri and Haldane (2009).
Institut C.D. HOWE Institute
 Essential Policy Intelligence  |  Conseils indispensables sur les politiques  e-brief | 2
The Plan 
In early 2010, Canada’s Minister of Finance and the Superintendent of Financial Institutions put their support behind a
proposal that would reduce the likelihood of bank failures and shift the costs of their rescue away from taxpayers. This
Embedded Contingent Capital proposal would require financial institutions to issue a special type of debt instrument that
would be converted into equity if their financial condition deteriorated beyond a certain point. This contingent capital
would be: 
... a notional systemic risk fund within the bank itself - a form of self insurance prefunded by private investors to protect the
solvency of the bank. Institutions would be required to raise [this contingent capital] by market issues that would be priced to
reflect the market’s assessments of the risk. (Dickson 2010a.)
The Office of the Superintendent of Financial Institutions (OSFI) has moved to implement this proposal through a
requirement that banks issue Non-Viability Contingent Capital (NVCC), a form of contingent capital that will replace types of
capital that will no longer qualify as Tier 1 or Tier 2 capital under the Basel III rules.
2Conversion of NVCC would be triggered
when the Superintendent judges that a bank has ceased to be viable and could potentially be restored to viability through
the conversion of the NVCC from debt to equity. Further, the terms of the conversion must significantly dilute the stake of
common shareholders, reflecting the principle that they, rather than taxpayers, bear the consequences of a bank’s situation.
The concept of contingent capital is neither new nor radical (Flannery 2005, Squam Lake Group 2009). It reverses a
prolonged trend toward weakening of shareholders’ and depositors’ interests in monitoring the affairs of banks. Until 1954,
for instance, shareholders were subject to double-liability, which made them liable in the event of failure for making
payments equal to the par value of their share holdings. Their role in overseeing banks was further diluted by limits on
concentrated ownership added in the 1967 Bank Act. The introduction of deposit insurance at the same time eliminated
concern by small depositors’ with the condition of their bank.
The Case for Contingent Capital 
A contingent capital requirement would have a number of benefits:
1. Contingent capital’s conversion would ease the process of dealing with troubled institutions by reducing outstanding 
fixed debt; 
2. At the same time, conversion would replenish shortfalls in the institution’s core capital;
3. The pricing of contingent capital by investors would strengthen market pressures on banks by making them bear more of the
costs of their risk taking;
4. Market pricing would be a signal to the regulator of the markets’ perception of the risk posed by an institution; 
5. Contingent capital would provide a cheaper safety buffer for well-run banks than additional equity capital.
3
Core equity provides the first line of defense by absorbing the shocks of an institution’s initial losses. Subordinated debt in
its present form, on the other hand, requires a complicated winding-up or restructuring of the troubled institution.
Contingent capital, though less automatic than equity, has the advantage over other debt in that the terms at which it is
converted and the timing of the conversion would be specified at the time the instruments are issued. 
2 The plans are set out in OSFI (2010a,b). Tier 1 and Tier 2 capital are categories of capital that are required under the Basel III Capital
Accord. Tier 1 capital consists of shareholders’ equity and serves as a first line of defence in absorbing losses. Tier 2 capital is
characterized as supplementary capital and is judged less permanent than Tier 1 capital. Tier 2 capital can include subordinated debt
and various reserves. 
3 If it did not, the financial institution could choose to use equity rather than contingent capital to meet its capital requirements.
E SSENTIAL P OLICY I NTELLIGENCE| 3 e-brief
Contingent Capital in Practice
The devil for any regulatory proposal is in the details. The devil for any contingent capital scheme is an expectation of
regulatory forbearance toward troubled banks. This expectation has been fostered by authorities historically having delayed
dealing with troubled institutions, especially those seen as “too big to fail.” This expectation could be overcome to some
degree by the design of a contingent capital plan. 
Timing: The timing of the trigger for conversion, early or late, will affect the working of contingent capital arrangements.
4
A late trigger could be based, as in the case for NVCC, on a regulator’s declaration that an institution is no longer viable, or
by government actions to directly support a troubled institution. A late trigger, however, would reinforce uncertainty about
the realization of the conversion in light of governments’ past tendencies to rescue troubled institutions. To avoid this
possibility, OSFI requires that the acceptance of “a capital injection or equivalent support” would also constitute a trigger
for conversion. Still, these long-term triggers could be delayed, or even avoided, if institutions were supported indirectly
through other measures such as asset purchases or extraordinary lending facilities. 
Early conversion, in contrast, could be based on criteria such as an institution’s failure to meet minimum capital
standards or by some measure of its market value. Full conversion at this stage would be disproportionate.
5 6 Such timing
could require OSFI to request banks to raise additional capital at some point prior to reaching the trigger point. This
request should be made public so as to reduce the impact of reaching the trigger on confidence in the bank. Such an early
timing would give banks the opportunity to raise additional capital before their situations become too dire.
Proportionality could be maintained by combining an early trigger with a phased conversion. Inevitably the opacity of
banks’ financial conditions will leave the authorities with some discretion over the timing of conversion. Early conversion is
likely to be more convincing when authorities have some leeway in their actions because it would demonstrate their
determination to act.
One advantage of an early trigger is that it reduces the risk of precipitating a run on the affected bank and the possibility
of spreading contagion to others. The early call would be less traumatic for several reasons.  Compared to a late call it
would signal a need to replenish capital to restore it to required levels rather than the more urgent need to preserve the
institution’s viability. In addition, an early trigger leaves scope for a less drastic phased conversion rather than the complete
conversion that would be required with a late trigger.
7
Terms of Conversion: The authorities have a choice between converting contingent capital for equity on the current
terms (share prices prevailing at the time of the trigger event) or on initial terms (those prevailing at the time the contingent
capital was issued). The choice of the terms will affect both the division of losses and the effects of contingent capital.
Setting the conversion at the equity’s market price at the time of conversion limits the pressures on holders of contingent
capital: the price of equity at that time would reflect the institution’s condition plus any anticipated dilution of equity. The
impact on contingent capital holders would consist of: 
i) any loss they suffer through replacing  their fixed debt instrument with equity; and 
ii) any subsequent losses because future market conditions turn out worse than expected at the time of the conversion.
4 De Sousa, Gravelle, Engert and Orsi (2010) refer to this difference as “going-concern” versus “gone-concern.”
5 An early trigger may be criticized because of the difficulties in determining when an institution actually fails to maintain capital at a
specified level. The weak conditions of major banks during the recent crisis were not signaled by the revelation that they missed the
required capital standards. The same problem would also bedevil any indicator used as a trigger for conversion, whether early or late.
6 Lloyds Bank chose an early trigger for conversion based on its tier 1 capital ratio falling below 5 percent for a debt issue it made in
November 2009. (See Hanson, Kashyap and Stein 2010,p.12.)
7 The call for conversion would provide new information to the market only if the condition of banks were not transparent. It is
difficult to justify concealing the condition of banks from the public. Such concealment effectively insulates management’s actions
from outside scrutiny and facilitates regulatory forbearance. See Allen, Carletti, and Poschmann (2009) for a statement of the case for
accounting transparency in banking.
E SSENTIAL P OLICY I NTELLIGENCEe-brief | 4
As noted by Goodlet (2010), conversion on the basis of prevailing market value would also be vulnerable to gaming by
holders of contingent debt hoping to improve the terms of conversion by depressing the price of the equity.
The effects of conversion based on issue price are quite different. In this scenario, debenture holders would be required
to convert the debt into equity at a conversion ratio set when the debenture was issued, even though share prices may have
fallen on the market. As before, the holders would suffer losses from the conversion of debt into equity. More of the losses,
however, would be shifted onto holders of convertible debt by exposing them to the full deterioration in equity value from
the time of issuance to the time of conversion. 
The choice between these options depends on the purposes of introducing contingent capital. In both cases, the
conversion reduces the fixed debt and replenishes the equity of troubled banks. Using initial equity prices  generates greater
market pressures on the pricing of contingent capital that would make it a barometer of a bank’s riskiness. 
The Costs of Contingent Capital
As proposed, contingent capital would replace other components of banks’ required capital and would arguably be more
expensive. Some of the added costs of contingent capital may be offset by reduced costs of other types of borrowing because
of the potential for a larger equity buffer. The added costs would probably not be excessive in light of the growing
consensus that even the effect of higher capital requirements on costs to bank customers’ would be small.
8
Nevertheless, added costs from using contingent capital would reflect a shift in the burden of troubled banks away from
taxpayers. That such potential costs to taxpayers currently exist can be seen from the two separate credit ratings for
Canadian banks. One system judges the banks’ own financial strength, and the other, a higher rating, reflects their implied
government support.
9 Any higher costs from the adoption of contingent capital requirements would then be the result of
investors’ judgments of the risks they would face that are now underwritten by the Canadian public.
Contingent Capital in Perspective
The strong performance of Canadian banks during the recent crisis makes it easy to argue that the introduction of
contingent capital is unnecessary. But we need to remember that Canadian authorities resorted to extraordinary measures
including loan guarantees, special lines of credit and substantial asset purchases to support our banks.
10 The fact that the
market capitalization of Canada’s five largest banks rose by $15 billion, or approximately 15 percent, on the heels of the
announcement of support suggests that it did much to bolster investors’ confidence. 
While Canadian banks navigated the crisis better than others, no two crises are the same and our banks could be more
vulnerable to the next one. Few would have imagined just few years ago that such large, well regarded banks as Bank of
America, Citibank, Royal Bank of Scotland, Credit Suisse, and many others would be on the ropes together. Adding
contingent capital now to the regulator’s tool kit is a wise measure that, when another crisis threatens, could reduce the
need to improvise on the fly. 
8 The Bank of Canada (2010) estimates the costs of a 1-percentage-point increase of capital ratios in terms of lending spreads to be
between 9 and 17 basis points for Canada. The Macroeconomic Assessment Group, the Basel Committee, and Elliott report 
similar results.
9 Moody’s second rating places each of the Canadian banks two levels above its stand-alone level. 
10 Many have pointed out that the banks did not take up the government’s offer of a loan guarantee. Nevertheless, the offer of a
guarantee itself constitutes a guarantee even if it is never used. 
E SSENTIAL P OLICY I NTELLIGENCE| 5 e-brief
This e-brief is a publication of the C.D. Howe Institute.
John F. Chant is is an Emeritus Professor of Economics at Simon Fraser University and a member of the Task Force for 
Payments System Review.
This e-brief is available at www.cdhowe.org.
Permission is granted to reprint this text if the content is not altered and proper attribution is provided.
References
Alessandri, P. and A. Haldane. 2009. “Banking on the State.” Presentation. November. Accessed at www,bankofengland.co.uk. 
Allen, F., E. Carletti and F. Poschmann. 2009. “Marking to Market for Financial Institutions: A Common Sense Resolution.” e-brief.
Toronto:C.D. Howe Institute. 
Bank of Canada.2010. “Strengthening International Capital and Liquidity Standards: A Macroeconomic Impact Assessment for Canada.”
August. 
Basel Committee on Banking Supervision. 2010. “An Assessment of the Long-term Economic Impact of the New Regulatory Framework.”
August. 
Brown K., and D. Enrich. 2008. Rubin, Under Fire, defends His Role at Citi –  “Nobody Was Prepared for Crisis of’08,” Wall Street
Journal. November 29, p. A1.
Cecchetti, S. 2010. “Strengthening the Financial System: Comparing Costs and Benefits.” Remarks prepared for the Korea-FSB Financial
Reform Conference 3 September. 
Dickson, J. 2010. “Protecting banks is best done by market discipline.” Financial Times April 9.
––––––––. 2010. “Too-big-to-fail and Embedded Contingent Capital.” Remarks to the Financial Services Invitational Forum, Cambridge,
Ontario. May 6.
D’Sousa, C., T. Gravelle, W. Engert and L.Orsi. 2010 “Contingent Capital and Bail-In Debt: Tools for Bank Resolution.” Bank of Canada
Financial System Review. December. 
Elliott, D. 2009. “Quantifying the Effects on Lending of Increased Capital Requirements.” Pew Financial Reform Project Briefing Paper, no 7.
Flannery, M.J. 2005. “No Pain, No Gain? Effecting Market Discipline via ‘Reverse Convertible Debentures,’” in Hal S. Scott, ed., Capital
Adequacy beyond Basel: Banking, Securities, and Insurance. Oxford: Oxford University Press. 
Goodlet, C. 2010. “Too-Big-to-Fail” – A Misguided and Overused Response to Financial Crises.” C.D. Howe Institute. October.. 
Hanson, S., A. Kashyap, and J. Stein. 2010. “ A Macroprudential Approach to Financial Regulation.” Paper prepared for the Journal of
Economic Perspectives.July.
Macroeconomic Assessment Group of the Financial Stability Board and Basel Committee on Banking Supervision. 2010. “Assessing the
Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements.” Bank for International Settlements.
August.
Office of the Superintendent of Financial Institutions. 2011a. “Advisory: Non-Viability Contingent Capital.”
Office of the Superintendent of Financial Institutions. 2011b. “Advisory: Treatment of Non-qualifying Capital Instruments. 
Squam Lake Working Group on Financial Regulation. 2009. “An Expedited Resolution Mechanism for Distressed Financial Firms:
Regulatory Hybrid Securities.”. Council on Foreign Relations Press. April.
E SSENTIAL P OLICY I NTELLIGENCE

A Macroprudential Approach to Financial Regulation.” Paper prepared for the Journal of Economic Perspectives.July.

Banking on the State.” Presentation. November. Accessed at www,bankofengland.co.uk.

Canada.2010. “Strengthening International Capital and Liquidity Standards: A Macroeconomic Impact Assessment for Canada.”

Committee on Banking Supervision.

Contingent Capital and Bail-In Debt: Tools for Bank Resolution.” Bank of Canada Financial System Review.

Macroeconomic Assessment Group of the Financial Stability Board and Basel Committee on Banking Supervision.

No Pain, No Gain? Effecting Market Discipline via ‘Reverse Convertible Debentures,’”

Office of the Superintendent of Financial Institutions.

Protecting banks is best done by market discipline.” Financial Times

Quantifying the Effects on Lending of Increased Capital Requirements.” Pew Financial Reform Project Briefing Paper, no 7.

Rubin, Under Fire, defends His Role at Citi – “Nobody Was Prepared for Crisis of’08,” Wall Street Journal.

Strengthening the Financial System: Comparing Costs and Benefits.” Remarks prepared for the Korea-FSB Financial Reform Conference

Too-big-to-fail and Embedded Contingent Capital.” Remarks to the Financial Services Invitational Forum,

Too-Big-to-Fail” – A Misguided and Overused Response to Financial Crises.” C.D. Howe Institute.

Working Group on Financial Regulation.

Strengthening Bank Regulation: OSFI's Contingent Capital Plan

Strengthening Bank Regulation: OSFI's Contingent Capital Plan

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics