Embedded contingent capital. This may sound like a term from another planet, but it is a concept which is slowly coming after the Canadian banking system. The Basel Committee paid attention to Canadian proposals and now actively discusses this new accounting principle in a hope to help preserve the stability of the banks of the world. Finance Minister Jim Flaherty was "pleased" Canada's ideas were taken into account.
The new rules redefine a new category for the qualification of banks' debt, Financial Times report. Up until now, debt (whether in the form of a bond of a loan) has been treated as a liability on the bank's part. Creditors-lenders are preferred to shareholders: in case a company goes bankrupt, creditors are compensated before any owners. On top of that, the debtor-creditor relationship is traditionally more systematic and creditors will recoup back the face value of the debt by the end of the lending term. This makes regular debt much less risky and less costly than equity.
The Basel Committee on Banking Supervision is an a union of central bank governors of ten nations world-wide. It meets quarterly and devises recommendations, guidelines and best practices that member and other states will be interested in implementing into their home law frameworks. The committee's resolutions do not automatically apply to each national market, but they are adhered to closely as unified law helps multinational banking houses are not required to use their own compliance management.
In the future, banks may make use of the option of converting portions of their debt to equity if they find themselves in financial distress. The conversion would come as a ruling of the federal government and would let banks enhance their levels of capital instantly. More capital may let the bank survive longer and hopefully all the way through to the end of the crisis. Therefore, the term "embedded contingent capital" is defined as capital embedded in the debt and contingent upon the bank's financial situation or the entire economy. The Canadian government must decide for the transformation.
These proposed rules are meant to prompt for stricter scrutiny of the bank's performance and lending practices. Being exposed to greater credit risk, lenders are expected to be better motivated to monitor their banks, the Basel Committee believes.
But is it really that important? LSM Insurance agrees that greater incentives are a good thing but will they be backed by legislation enhancing transparency of the banking transactions so that there are tools for investors to understand their banks effectively? Plus, even today, investors are interested in the well-being of their banks. While the change may add additional pairs of eyes interested in the matter, the marginal benefit is still questionable.
LSM Insurance believes that the chief implication of these new regulations for the banks themselves will be their ability to acquire financing in a new way that is cheaper than equity but a little dearer than just ordinary (unconvertible) debt.
Debt (in the form of loans and bonds) obliges the debtors to pay back in regular agreed upon instalments according to a contracted payment schedule. In any case, the face value of the debt is always paid back to the lender at the end of the term. Equity, on the other hand, gives the shareholder a portion of ownership, including voting rights, but it is up to the company's management to choose the size of the dividends in a given year. Also, shareowners can't expect the face value of their investment to be returned to them at the end of the term and the only way they can recoup their money is to re-sell their share hold to another investor or, less frequently, back to the issuing company.
If the banks take advantage this "third" borrowing facility, their weighted average cost of capital will increase slightly. But for that price, they'll have an interesting safety measure in place to resort to in case worse comes to worst. There must of course be a market for this kind of an instrument, which is still a large question mark in a market as small as the Canadian one Nonetheless, the banks appear to expect that the hassle will be worth it eventually. The reassuring factor is that the contingency steps in only if the federal government gives it the green light and is not up to the banks themselves.
According to Reuters, bankers in Canada say they are quite prepared to adopt the new rules. From their current position, they want to continue in their successful post-crisis growth. Banks and analysts are envisaging mergers and acquisitions both at home and abroad. Our banks could be expected to compound their presence in the US and European markets.