In Budget 2013, Finance Minister Jim Flaherty proposed the establishment of a risk management framework for systemically important banks. At first glance, the proposal looks fairly innocuous (See Pages 144-145 of the Budget document available here) because the Minister is simply proposing that the Government of Canada “intends to implement a comprehensive risk management framework” for the Big Six banks. The framework will include higher capital requirements, a “bail-in” regime that will convert “certain bank liabilities” into regulatory capital and more oversight from regulators.
Many Canadians (aided and abetted by certain vested interests) began to conclude that the Canadian Government is calling for insured bank deposits to take a haircut in the event of a major bank failure. That does not appear to be the case. Bail-in simply refers to a partial conversion of certain unsecured debt into equity under specific conditions. A 2011 paper titled Contingent Capital and Bail-In Debt: Tools for Bank Resolution put out by the Bank of Canada has some ideas on the liabilities that can be converted into equity [emphasis mine]:
There is some debate about the scope of the liabilities that should be subject to such bail-in conversion, but a focus on senior, unsecured debt instruments would be relatively straightforward. This particular scope of application would leave secured creditors, insurable depositors, short-term securities holders and a bank’s counterparties unaffected by bail-in provisions.
In other words, deposits in a bank up to CDIC insurance limits will likely be safe during a bank failure. In fact, The Financial Post is now reporting that a Finance Ministry spokeswoman clarified that “the bail-in scenario described in the budget has nothing to do with depositors’ accounts and they will in no way be used here.”
One would think that a bail-in mechanism for banks is a good thing because recapitalizing too-big-to-fail institutions with tax payer money (a.k.a bail outs) while leaving bond, preferred-share and sometimes even equity investors with little or no losses will incentivize reckless risk taking. After all, who wouldn’t love to gorge on a free lunch if someone else gets a stomach ache?
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