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The problem with Canada’s bail-in rules


Canada should have thought twice before stripping banks of their ability to use senior debt as an ordinary funding tool.

There has a been a bit of a wait for the introduction of a bail-in regime in Canada, but the new rules will finally apply to banks from this week onwards.

The starting gun was fired on September 23, giving the Canada Deposit Insurance Corporation the power to restructure new senior bonds issued by any of the country’s six largest banks.

Senior debt issued before that date will not be subject to bail-in and will be phased out as it matures over the next decade or so.

None of this is particularly onerous for the well-rated Canadian banks, which shouldn’t face too much of a struggle replacing legacy senior securities with new bail-inable bonds in the coming years.

But it was needlessly disadvantageous for the country’s Office of the Superintendent of Financial Institutions (OSFI) to get rid of any way for financial institutions to continue using senior unsecured debt as a pure funding tool.

From now on, every senior bond issued by BMO Financial, CIBC, National Bank of Canada, Royal Bank of Canada, Scotiabank or Toronto Dominion will come with a sticker saying “bail-in” plastered all over it.

Peter Simon, a senior analyst at CreditSights, reckons this will add about 8bp-15bp onto the cost of issuing senior debt with a five year tenor, and the main rating agencies have generally taken to downgrading this kind of issuance by up to three notches.

Once they have complied with their requirements for having loss-absorbing debt (TLAC), Canadian banks will still be able to offset any clear rise in their cost of funding by issuing cheaper securities like covered bonds or structured debt.

But this situation is far from perfect. It is far from ideal to make Canada's banks rely on funding that needs to be backed by a pool of assets, and this could eventually put them at risk of breaching the regulator’s cap on asset encumbrance — at 4% of total assets.

This should all be pretty galling for Canadian bank treasury officials, because it didn’t have to be this way.

OSFI had plenty of other jurisdictions that it could have copied or taken inspiration from when drawing up its bail-in framework.

In Europe, for example, rulemakers lent more loss-absorbing capacity to the senior debt layer by chopping this part of the liability stack in half to produce non-preferred senior bonds, which are specifically designed for bail-in, and preferred senior notes, which are not.

OSFI need only have asked German lenders what they thought of having the option to issue a funding-only form of senior debt.

There was a palpable sense of relief when this option was given back them in July. They wasted no time in hitting the market with preferred senior deals, shaving 20bp-25bp off of their cost of issuing TLAC-eligible equivalents.

Few are now disputing the logic of putting long-term debt in the firing line for when a bank hits trouble, shifting the financial burden of dealing with any failures onto professional investors and away from taxpayers.

But Canada’s approach to this issue has been needlessly heavy-handed.

Making it easy to use bail-in on banks does not have to mean reducing the number of tools in the funding toolbox.