Canadian banking regulators are touting the use of embedded contingent capital as the solution to the “too big to fail” problem that has been looming over policymakers since they found themselves bailing out big banks as a result of the financial crisis.

Speaking to the Financial Services Invitational Forum in Cambridge, Ont., Canada’s top banking regulator, superintendent Julie Dickson, argued against possible steps to defuse moral hazard attached to banks that are so big, or so important, that governments will never let them fail, such as bank taxes, size limits, or capital surcharges.

“Let me be clear, too-big-to-fail is a serious problem. Tackling it is difficult, and to be frank, many of the proposals put forward to date do not seem to deal with it credibly,” she said, adding that the Office of the Superintendent of Financial Institutions Canada favours efforts to develop embedded contingent capital to deal with this issue.

“Embedded contingent capital is a security that converts to common equity when a bank is in serious trouble, thereby replenishing the core capital of the bank without the use of taxpayer dollars,” Dickson explained. “It would apply to all subordinated securities and depending on calibration efforts, would likely be equivalent in value to at least the regulatory requirements for common equity. This would create a notional systemic risk fund embedded within the bank itself – a form of self-insurance pre-funded by private investors to protect the solvency of the bank.”

Under such a model, governments would not bail out any bank unless the conversion of contingent capital had taken place. “This would ensure that penalties would be doled out appropriately, and that taxpayers would not have to foot the entire bill. As well, the larger the contingent capital buffer, the less need there would be for government funds,” she said.

“Another advantage of embedded contingent capital is that it avoids any need to create a systemic risk fund, which could lead to concerns about what to do with such a fund over time. Instead, investors with a financial interest would decide what each bank should pay when contingent capital was issued – with riskier banks penalized by the market. Thus, regulators would not have to develop a specific charge on systemically-important institutions, which is extremely difficult to do,” she added.

Dickson also said that contingent capital would be priced as debt, making it more affordable to banks, and minimizing the cost to be passed on to bank clients.

“For Canadian institutions, I think there is much to be gained by focusing on embedded contingent capital. Indeed, the more the market considers an institution to be well run, on top of their risks, transparent about their risks and the quality of their portfolios, and well regulated, the cheaper it will be for them to issue contingent capital,” she said.

“Too-big-to-fail and moral hazard need to be addressed. Surcharges, taxes, levies, and size limits are not receiving universal acceptance, and are fraught with conceptual and practical difficulties. For this reason, embedded contingent capital deserves focus,” Dickson concluded.

“Either through contingent capital or in other ways, large financial institutions do have something to gain by using their creative energy to find ways to deal with too-big-to-fail – otherwise they may not like what is created for them.”

IE