TAX NEWS - June 2010

Canada Tax: Bankers cast doubt on tax alternative

There's just one problem with Canada's alternative to a bank tax: Bankers and the country's financial regulator aren't sure it will work.

Some Canadian bankers are skeptical about the feasibility of Ottawa's proposal for a new type of security that would enable banks to "self-insure" against failure, a key part of the country's fight against plans for a global bank tax.

The federal government opposes the idea of a global bank tax, and policy makers are trying to persuade their foreign counterparts to consider securities called "embedded contingent capital" as an alternative.

Embedded contingent capital (ECC) is envisioned as a kind of debt security that would convert into common shares just prior to a bank failing. That sudden infusion of equity would boost the bank's capital levels, helping to give the bank and regulators time to find a solution for the ailing institution.

A key stumbling block, bankers say, is that the contingent capital securities would come with so much risk that investors will demand a high interest rate to buy them. That will make selling the securities unattractive to banks and could even lead to the securities being more costly to banks than a bank tax, some analysts say.

Canada's Office of the Superintendent of Financial Institutions (OSFI), which has been spearheading the push for contingent capital, acknowledges that the market may decide it is not a good solution.

"It will be up to the issuers, the investment bankers and the investors and the rating agencies and the accountants – all the different stakeholders that have to be involved in a securities issuance – to decide whether it's real or not," said Mark White, assistant superintendent at OSFI. "So we're really just trying to create an alternative."

OSFI has been discussing the idea with international regulators and officials for some time and is hopeful that they will adopt it. But if they don't, it could still be implemented in Canada, where the regulator has more recently reached out to Bay Street bankers and Canadian investors to gauge their response.

"At this point we are pursuing the international option," Mr. White said. "We would not consider a national go-it-alone strategy until we'd exhausted the international option."

The biggest issue with the idea, some bankers say, is the potential conversion from debt to common stock. The last thing a debt investor wants is to end up owning equity in a troubled company, bankers said. That's because in the event of a bankruptcy or liquidation, common shares rank behind debt. As a result, investors demand much higher returns from equity-like securities, making them more costly for the selling bank.

Also, many big investors such as some pension funds are not allowed to buy debt that converts into equity. That shrinks the potential market, again increasing the cost for banks.

"If this is priced more like equity it becomes very, very expensive, probably even more so than a bank tax," said lawyer Blair Keefe, head of Torys LLP's financial institutions group.

OSFI has acknowledged the issue of pricing. OSFI head Julie Dickson said in a speech recently that "being priced as debt is critical, as it makes it far more affordable for banks, and therefore has the benefit of minimizing the impact on the costs of consumer and business loans."

The Canadian Bankers Association, the umbrella industry group, has highlighted the issue of finding buyers. "Careful consideration must also be given to the cost and marketability of such an instrument, particularly in a smaller market like Canada, which has a concentrated investor base," the group said.

Selling ECC securities could raise a bank's cost of capital by as much as one to two percentage points, reducing earnings by 4 per cent to 7 per cent, analyst John Reucassel of BMO Nesbitt Burns said in a note to clients. Mr. Reucassel said banks may also have to pay more to issue preferred shares, which are a big source of capital. That's because preferred shares would rank below the new ECC notes in the capital structure of the bank, he said.

Other fears include the possibility that hedge funds or other investors could game the system, and that the conversion features could actually create more instability for a bank that's in trouble and lead to a death spiral of dilution, Mr. Keefe said.

The primary benefit of the contingent capital idea, he said, "is that it's better than the other alternatives that have been floated."