Modernizing Ontario’s Credit Union Legislative Framework
Consultation Paper on a Proposed Capital Adequacy Framework

November 2017

Table of Contents

Introduction

Please note that the deadline for comments on the Consultation Paper on a Proposed Capital Adequacy Framework has been extended to February 28th

In the 2016 Ontario Budget, the government announced its intention to implement the recommendations contained in the November 2015 report (“2015 Report”) following the review of the Credit Unions and Caisses Populaires Act, 1994 (“CUCPA” or “the Act”). One of the recommendations in the 2015 Report was the adoption of updated capital adequacy requirements for Ontario credit unions based on Basel III principles, with appropriate adjustments to reflect the capital structure of credit unions. This consultation paper sets out a detailed proposal prepared by Ministry of Finance staff for implementing this recommendation. The purpose of this paper is to seek feedback from the credit union sector and other interested parties. This paper does not necessarily represent the position or views of the Government of Ontario.

While developing the proposals contained in this document, the Ministry of Finance sought the input of the Deposit Insurance Corporation of Ontario (DICO) and the Financial Services Commission of Ontario (FSCO). DICO is the prudential regulator and deposit insurer for Ontario’s credit union sector. FSCO is the market conduct regulator and is responsible for incorporating credit unions, approving changes to their charter, as well as for certain approvals under the Act, and for reviewing complaints against credit unions.

Structure of Paper

This consultation paper consists of ten sections discussing various aspects of the framework:

  • Section 1 provides an overview of key elements of the existing capital adequacy standards in the CUCPA and the international capital adequacy standard Basel III that is considered a best practice for deposit-taking institutions globally
  • Section 2 identifies the key changes that would be necessary in order to align Ontario’s capital adequacy framework for credit unions more closely with Basel III
  • Sections 3 to 9 describe specific measures being proposed to more closely align Ontario’s capital adequacy framework for credit unions with Basel III, including proposed transitional measures to phase-in certain requirements discussed in Section 9
  • Section 10 poses a list of key consultation questions

Throughout this consultation paper, reference is made to sections of the CUCPA and Ontario Regulation 237/09 made under the Act (“the General Regulation”), both of which can be accessed online at http://www.ontario.ca/laws.

Please note that the term “credit unions”, as used throughout this paper, is intended to include “caisses populaires”.

How to Participate

Your views are being sought on the proposals in this paper. Please see Section 10 for specific consultation questions. However, feedback need not be limited to the scope of the questions. Interested parties are invited to make written submissions by February 28th, 2018. You may send comments by mail or e-mail to:

Modernizing the CUCPA
c/o Financial Services Policy Division
Ministry of Finance
95 Grosvenor St, Frost Building North 4th Floor
Toronto, ON M7A 1Z1
E-Mail: CUCPA.consultation@ontario.ca

A copy of this consultation document can be reviewed online at www.fin.gov.on.ca.

Please note that this is a public consultation. All comments received will be considered public and may be used by the ministry to help evaluate and revise the legislative proposals. This may involve disclosing some or all comments or materials, or summaries of them, to other interested parties during and after the consultation. Personal information will not be disclosed without prior consent.

All submissions received are subject to the Freedom of Information and Protection of Privacy Act.

If you have any questions about this consultation or how any element of your submission may be used or disclosed, please contact: CUCPA.consultation@ontario.ca.

After comments are reviewed and considered, it is anticipated that capital adequacy requirements will be incorporated into draft legislation to replace the existing CUCPA, for the government’s consideration. If such legislation is enacted, further details regarding capital adequacy are anticipated to be incorporated into regulations made under the new legislation, or other instruments issued by the prudential regulator. 

1 Overview of Capital Adequacy Requirements

Current CUCPA Requirements and Basel II

In order to ensure financial stability and protect depositors, the CUCPA requires that Ontario credit unions hold minimum levels of capital. The current capital requirements are comprised of two elements – a leverage ratio test and a risk-based capital ratio test – both of which are derived from international standards agreed upon in 2004 by the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland. These standards are often referred to as the Basel II capital rules. Although initially the Basel II accord was applied only to internationally active banks in the G10 countries, it has become a recognized standard in many jurisdictions for different types of deposit-taking institutions.

The Basel II framework consists of three pillars:

  1. Pillar 1 calculates the required minimum levels of capital based on credit, operational and market risks at individual institutions (including the leverage and risk-based capital ratio tests described above)
  2. Pillar 2 requires capital for additional risks identified based on internal management processes
  3. Pillar 3 requires enhanced disclosure to investors and the public, as well as reporting of risks and capital levels to cover those risks

Basel III

In 2010 and in subsequent years, the BCBS introduced further reforms to strengthen global capital rules to promote a more resilient financial institutions sector, commonly referred to as Basel III. This new standard reinforces the Pillar 1 requirements of Basel II by increasing the minimum required levels of higher quality capital, requiring capital conservation and countercyclical buffers, introducing contingent capital, enhancing risk coverage for certain transactions such as securitizations, and including off-balance sheet and other items in the leverage ratio test. Additional Basel III reforms, such as proposals for a model-based credit risk framework and a simplified market risk framework, are still under development.1

Similar to Basel II, the Basel III standard was initially applied only to internationally active banks, but it has also become a recognized standard for other deposit-taking institutions globally, including credit unions. In Canada, this standard became effective for federally-regulated Canadian deposit-taking institutions in January 2013, and applies to federal credit unions. Quebec and Saskatchewan have also adopted capital rules in line with the Basel III standard that apply to credit unions in their provinces.

The Basel III standard acknowledges that the proposed framework is not tailored to the unique legal and capital structure of co-operative and mutual financial institutions, and provides some flexibility to jurisdictions in applying the Basel III criteria to such entities.

Previous Feedback from Credit Union Sector and Scope of Current Consultation

During consultations leading up to the 2015 Report, most Ontario credit unions indicated that they were generally supportive of a move towards stronger capital requirements. However, credit unions were concerned that they would not be able to meet the minimum Common Equity Tier 1 (CET1) capital requirements under the Basel III framework, due to their reliance on investment shares and the characteristics of such shares.

This paper describes proposed changes to the existing capital framework under the CUCPA in order to harmonize with the Pillar 1 requirements of Basel III while making appropriate modifications to reflect Ontario’s credit union sector. In developing these proposals, current practices for co-operative and mutual financial institutions in other jurisdictions across Canada and internationally were considered. Pillar 2 objectives are primarily achieved through DICO’s Internal Capital Adequacy Assessment Process (ICAAP)2, which applies to credit unions with more than $500 million in assets. Pillar 3 requirements will be further considered in the future as part of reviewing disclosure rules under the CUCPA.  Requirements under the CUCPA that already satisfy Basel III requirements (e.g., operational risk charge rules) are not discussed in this paper.

2 Basel III – Potential Impact on Ontario Credit Unions

Adopting a capital adequacy framework based on Basel III principles would result in several key changes to Ontario’s existing capital framework for credit unions.  These changes would include:

  • New categories of capital
  • Increased minimum levels of capital for each category
  • Expanded criteria for each category of capital
  • A new resolution tool for the prudential regulator
  • Additional regulatory adjustments to capital
  • New risk-weighting rules, impacted by new credit risk requirements
  • Augmented leverage ratio requirements

Sections 3 to 9 of this consultation paper discuss these changes in further detail. Basel III requirements from the BCBS document, Basel III: A global regulatory framework for more resilient banks and banking systems (revised version June 2011) and other related standards, are quoted and at times paraphrased in grey boxes, with references to specific paragraph numbers from the standard in square brackets.

3 Categories of Capital

What is the current Ontario requirement?

Currently, section 17 of the General Regulation prescribes two categories of capital – Tier 1 and Tier 2.

What is the Basel III standard?

Total regulatory capital consists of the sum of the following categories:

  1. Tier 1 capital, consisting of:
    1. Common Equity Tier 1 capital (CET1)
    2. Additional Tier 1 capital (AT1)
  2. Tier 2 capital (T2)

For each of the three categories above (1a, 1b and 2) there is a single set of criteria that instruments are required to meet before inclusion in the relevant category. [BCBS 2011, par 49]

What is the proposed approach?

It is proposed that the Basel III categories of regulatory capital – CET1, AT1 and T2 – be adopted for Ontario credit unions. The split in Tier 1 capital between CET1 and AT1 emphasizes the importance of CET1 as the highest quality of capital with specific characteristics, such as permanence, subordination, and loss-absorbency. These characteristics enable credit unions to withstand periodic shocks in the market.

In order to better reflect the cooperative share capital structure of credit unions, this proposal defines the acronym CET1 as “Core Equity Tier 1” instead of the Basel III term “Common Equity Tier 1”, which contemplates a joint-stock company structure.

4 Criteria for Inclusion in Categories of Capital

This section describes how Ontario could adopt the Basel III criteria for each category of credit union capital.

4.1 Tier 1 Capital

What is the current Ontario requirement?

Tier 1 capital of a credit union is currently described in subsection 17(2) of the General Regulation using amounts on the credit union’s financial statements prepared as of the date of calculation of regulatory capital, including:

  • Retained earnings
  • Contributed surplus
  • Membership shares
  • Patronage shares other than those patronage shares that are redeemable within 12-months period following the date of calculation
  • Qualifying shares which meet certain conditions described in subsection 17(4) of the General Regulation, other than qualifying shares that are redeemable within the 12 month period following the date of calculation  (investment shares)
  • Accumulated net after tax unrealized loss on available-for-sale equity securities reported in Other Comprehensive Income
  • Certain deductions prescribed in subsection 16(1) of the General Regulation, including goodwill, certain amounts of intangible asset balances, and investments in subsidiaries that are financial institutions. See Section 7 for proposed amendments to regulatory adjustments.

What is the Basel III standard?

Basel III requires capital items included in each category of CET1, AT1 and T2 to have certain prescribed characteristics. This ensures that financial institutions hold sufficient high-quality capital with qualities of permanence and loss-absorbency that allows the financial institution to remain viable in the long-term.

4.1.1   Core Equity Tier 1

What is the Basel III standard?

Basel III requires CET1 to consist of the sum of the following elements:

  • Common shares issued by the bank that meet the criteria for classification as common shares for regulatory purposes (or the equivalent for non-joint stock companies)
  • Stock surplus (share premium) resulting from the issue of instruments included in CET1
  • Retained earnings
  • Accumulated other comprehensive income and other disclosed reserves
  • Common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e. minority interest) that meet the criteria for inclusion in CET1 capital
  • Regulatory adjustments applied in the calculation of CET1

For an instrument to be included in CET1 capital, it must meet all of the criteria in Appendix B. Footnote 12 of the Basel III standard indicates that the criteria for classification in CET1 also apply to non-joint stock companies, which are defined as companies that do not issue common shares privately or publicly. The application of the criteria should preserve the quality of the instruments by requiring that they are deemed fully equivalent to common shares in terms of their capital quality and do not possess features which could cause the condition of the company to be weakened as a going concern during periods of market stress. [BCBS 2011, par 52-53]

What is the proposed approach?

It is proposed that CET1 for Ontario credit union capital consist of the sum of the following elements:

  • Retained earnings
  • Membership shares that satisfy the criteria set out in Appendix B with some modifications as described below
  • Core capital shares that satisfy the criteria set out in Appendix B with some modifications as described below
  • Accumulated net after tax unrealized loss on available-for-sale equity securities reported in Accumulated Other Comprehensive Income
  • Common shares issued by consolidated subsidiaries of the credit union and held by third parties (i.e. minority interest) that satisfy the criteria set out in Appendix B
  • Stock surplus (share premium) resulting from the issue of shares included in CET1 as is currently allowed under section 17 of the General Regulation
  • Regulatory adjustments applied in the calculation of CET1 with modifications described in Section 7

These proposed components of CET1 are similar to what is allowed for federal credit unions under the Capital Adequacy Requirements Guideline issued by the Office of the Superintendent of Financial Institutions (OSFI).

Membership shares

One of the key challenges in modifying the Basel III standard to accommodate the unique capital structure of credit unions is the absence of common shares. The key characteristics of common shares that qualify them as the highest quality of capital are their permanence and claim to residual assets of the issuing institution. Permanence means that shareholders do not have any expectation that the issuing institution will redeem their shares in the future. Claim to residual assets means that shareholders would receive the remaining assets in the event of a dissolution after the claims of all creditors and priority shareholders have been satisfied.

Currently under the CUCPA, membership shares have claims to residual assets of the credit union, similar to common shares. However, they do not have the required degree of permanence to be classified as CET1. In order to enhance the permanence of membership shares so that they could qualify as CET1, it is proposed that:

  • All share redemptions would not be at the member’s sole discretion and the credit union must have the unconditional right to refuse redemption
  • All share redemptions would require prior approval by the prudential regulator. Further consideration will be given by the prudential regulator to the approval of normal course issuer bid redemptions
  • Shares could not be redeemed if the redemption would result in the credit union failing to meet regulatory capital or liquidity requirements

This modification would allow membership shares to meet the Basel III criteria 3 and 4 in Appendix B.

Core capital shares

In order to provide credit unions with opportunities to raise additional CET1 capital outside of retained earnings and membership shares, and to allow credit unions to convert existing investment shares into CET1-compliant capital, it is proposed that a new type of share – core capital share – be created that would qualify for inclusion in CET1. Core capital shares would need to meet all of the CET1 characteristics of permanence, subordination, and residual claims to assets detailed in Appendix B, as well as have the following features:

  • Claims to residual assets: Core capital shares would be entitled to claims on the residual assets of a credit union that would rank equally with the claim entitlements of membership shares up to a specified cap. Any assets remaining after the cap is reached would be distributed exclusively to the credit union’s members. This is in line with the approaches implemented by OSFI for federal credit unions, the European Union and other jurisdictions internationally
  • Permanence: Similar redemption characteristics would apply to core capital shares as membership shares (as described above), including the requirement to obtain approval from the prudential regulator for redemptions
  • Conversion: Core capital shares could be created as a result of amending the terms and conditions of investment shares

These modifications would allow core capital shares to meet Basel III criteria 1, 2, and 8 in Appendix B in order to qualify for CET1.

Contractual cap

Distributions on CET1 shares may be subject to a contractual cap or restriction. This would be a departure from the Basel III framework in order to accommodate the structure of credit union shares. This approach is consistent with the approaches implemented by OSFI and the European Union in respect of credit unions.

Accumulated other comprehensive income (AOCI)

The impact of AOCI items on CET1 capital of credit unions is substantially the same between Basel III and the current requirements in the General Regulation.

4.1.2   Additional Tier 1 Capital

What is the Basel III standard?

Basel III requires that Additional Tier 1 (AT1) capital consists of the sum of the following elements:

  • Instruments issued by the bank that meet the criteria for inclusion in AT1 capital (and are not included in CET1)
  • Stock surplus (share premium) resulting from the issue of instruments included in AT1 capital
  • Instruments issued by consolidated subsidiaries of the bank and held by third parties that meet the criteria for inclusion in AT1 capital and are not included in CET1
  • Regulatory adjustments applied in the calculation of AT1 capital

The full list of AT1 criteria is detailed in Appendix C. [BCBS 2011, par 54]

What is the proposed approach?

It is proposed that credit union AT1 capital consist of the sum of the following elements:

  • Investment and patronage shares that meet the criteria set out in Appendix C with some modifications as described below
  • Stock surplus (share premium) resulting from the issue of shares included in AT1 capital, as is currently allowed under section 17 of the General Regulation
  • Common shares issued by consolidated subsidiaries of the credit union and held by third parties (i.e. minority interest) that meet the criteria for inclusion in Appendix C
  • Regulatory adjustments applied in the calculation of Additional Tier 1 capital with modifications described in Section 7
Investment and other qualifying shares

Most investment shares currently issued by Ontario credit unions would not qualify for AT1 treatment under Basel III, as they do not meet Basel III’s definition of permanence. To address this issue, the government has announced its intention to include investment shares in the computation of AT1 capital, as recommended in the 2015 Report, provided that:

  • All share redemptions be approved by the prudential regulator
  • Shares redemptions would not be permitted if the redemption would result in the credit union failing to meet regulatory capital or liquidity requirements
  • Any new investment shares issued should contain the provision that they cannot be redeemed at the member’s sole discretion and the credit union must have an unconditional right to refuse redemption
  • Existing investment shares outstanding would be included in Tier 1 capital for a grandfathered period of five years. Refer to Section 9 for transitional proposals

It is proposed that the same criteria also apply to patronage shares so that they could qualify for inclusion in the computation of AT1 capital. These modifications would allow investment and patronage shares to meet Basel III criteria 4 in Appendix C relating to permanence.

Some of the additional Basel III key criteria, set out in more detail in Appendix C, would impact the existing terms of investment and patronage shares:

  • Shares would not contain a maturity date or other incentives for the credit union to redeem them (Criteria 4 in Appendix C).
  • A credit union’s actions must not create an expectation that a call will be exercised, and a credit union must not exercise a call unless:
    • It replaces the called share with capital of the same or better quality, and the replacement of this capital reflects conditions which are sustainable for the income capacity of the credit union, or
    • The credit union demonstrates to the prudential regulator that its capital position would continue to exceed the minimum capital requirements after the call option is exercised (Criteria 5 in Appendix C)
Classification as a liability

Basel III AT1 Criteria 11 states that equity instruments classified as liabilities for accounting purposes may be automatically converted or written-down when a financial institution reaches a certain threshold of CET1 capital. It is proposed that this Basel III criterion not be adopted for Ontario credit unions, as such terms may reduce investor confidence in credit union shares. It is proposed that, in line with the approach adopted by OSFI, AT1 instruments are required to be classified as equity for accounting purposes, except for investment shares.

4.2 Tier 2 Capital

What is the current Ontario requirement?

Subsection 17(3) of the General Regulation describes items that are currently included in T2 capital. It is determined using amounts on the credit union’s financial statements prepared as of the date of calculation of regulatory capital, including:

  • Patronage shares that are redeemable within the 12-month period following the date of calculation
  • Fully paid shares issued by the credit union, excluding membership shares, patronage shares and qualifying shares that are included in Tier 1 capital
  • Subordinated indebtedness that cannot be redeemed or purchased for cancellation in the first five years after it is issued, and is not convertible into or exchangeable for a security other than a qualifying share
  • The amount of any loan loss allowance, not including an individual loan loss allowance, up to a maximum of 0.75% of total assets for a Class 1 credit union and 1.25% of risk-weighted assets for a Class 2 credit union. Effective January 1, 2018, the distinction between Class 1 and Class 2 credit unions will be eliminated and all existing Class 1 credit unions will be subject to the same loan loss allowance of 1.25% of total assets
  • Accumulated net after tax unrealized gain on available-for-sale equity securities reported in Other Comprehensive Income
  • Certain deductions set out in the current Capital Adequacy Guideline for Ontario’s Credit Unions and Caisses Populaires3, such as the accumulated actuarial losses for any defined benefit pension fund liability included on the balance sheet where the losses have been accounted for through AOCI. See Section 7 for proposed amendments to regulatory adjustments

What is the Basel III standard?

Basel III requires that Tier 2 (T2) capital consist of the sum of the following elements:

  • Instruments issued by the bank that meet the criteria for inclusion in T2 capital (and are not included in Tier 1 capital)
  • Stock surplus (share premium) resulting from the issue of instruments included in T2 capital
  • Instruments issued by consolidated subsidiaries of the bank and held by third parties that meet the criteria for inclusion in T2 capital and are not included in Tier 1 capital
  • Certain loan loss provisions
  • Regulatory adjustments applied in the calculation of T2 Capital

The full list of T2 criteria is detailed in Appendix D. [BCBS 2011, par 57]

What is the proposed approach?

It is proposed that credit union T2 capital consist of the sum of the following elements:

  • Investment, patronage and membership shares that meet the criteria set out in Appendix D
  • Common shares issued by consolidated subsidiaries of the credit union and held by third parties (i.e. minority interest) that meet the criteria for inclusion in Appendix D
  • Stock surplus (share premium) resulting from the issue of instruments included in T2 capital
  • General loan loss allowance up to 1.25% of risk-weighted assets for all credit unions, which will, as of January 1, 2018, be allowed for all credit unions pursuant to paragraph 4 of subsection 17(3) of the General Regulation
  • Regulatory adjustments applied in the calculation of T2 capital with proposed modifications described in Section 7

Generally, existing investment shares currently qualify for T2 capital treatment under Basel III. Some key characteristics of shares qualifying for T2 capital treatment, further detailed in Appendix D, are:

  • The instrument must have a minimum original maturity date of 5 years and the issued capital balance would be amortized on a straight-line basis over 5 years to maturity (Criteria 4 in Appendix D)
  • The shares should have the same call option characteristics as AT1 instruments described above (Criteria 5 in Appendix D)

5 New Resolution Tool for the Prudential Regulator

What is the Basel III standard?

Basel III requires a contingent capital term to be integrated within the share terms and conditions of all AT1 and T2 shares. The contingent capital term is a resolution tool that allows the prudential regulator to write-down or convert AT1 and T2 shares into CET1 shares when it is determined that a significant financial institution is about to become non-viable. The aim of this requirement is to recapitalize a systemically important financial institution (SIFI) with the goal of returning it to viability by the prudential regulator, and to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss, where the government determines that it is in the public interest to rescue a non-viable institution.

What is the proposed approach?

In line with approaches adopted for credit unions by OSFI and the European Union, it is proposed that this Basel III requirement be adopted with some modifications. This would allow the prudential regulator, at the point of non-viability, to trigger full and permanent conversion of AT1 and T2 shares into non-voting core capital shares that are eligible for recognition as CET1 capital. This requirement would provide an additional resolution tool to the prudential regulator to be able to quickly and effectively restructure and recapitalize a systemically important credit union in Ontario.  

It is anticipated that the point of non-viability would be determined by the prudential regulator in accordance with criteria similar to those detailed in paragraphs 45 to 47 of OSFI’s Capital Adequacy Requirements Guideline, Chapter 2.

6 Minimum Capital Requirements

This section describes key proposed changes to Ontario’s current risk-based capital and leverage ratios for credit unions.

6.1 Risk-based capital ratio

What is the current Ontario requirement?

Currently, the General Regulation imposes risk-based capital ratio requirements on Class 2 credit unions. Class 2 credit unions have assets greater than or equal to $50 million or engage in commercial lending, while Class 1 credit unions have total assets of less than $50 million or do not engage in commercial lending. Effective January 1, 2018, amendments to the General Regulation will eliminate the distinction between Class 1 and Class 2 credit unions, resulting in all credit unions being required to maintain a minimum risk-based capital ratio of 8%.

The minimum risk-based capital ratio is currently calculated based on non-consolidated financial statements of the credit union, where a credit union’s investments in subsidiaries are recorded using the equity method of accounting as described in the Capital Adequacy Guideline for Ontario’s Credit Unions and Caisses Populaires.

Ontario does not currently have any capital conservation buffer or countercyclical buffer requirements for credit unions.

What is the Basel III standard?

  • CET 1 capital must be at least 4.5% of risk-weighted assets at all times
  • A capital conservation buffer of 2.5% must be held in addition to the CET1 minimum capital requirement [BCBS June 2011, par 129]
  • Total Tier 1 capital must be at least 6.0% of risk-weighted assets at all times
  • Total Capital (Tier 1 capital plus Tier 2 capital) must be at least 8.0% of risk-weighted assets at all times  [BCBS June 2011, par 50]

The sum of the above would bring the minimum Total Capital requirement to 10.5%. In addition, a countercyclical buffer that varies between zero and 2.5% must be held in addition to the CET1 minimum capital requirement. [BCBS June 2011, par 142]

Capital Conservation Buffer: Capital distribution constraints will be imposed on a bank when capital levels fall below 2.5%. [BCBS June 2011, par 129] The table reproduced in Appendix A shows the minimum capital conservation ratios a bank must meet at various levels of the CET1 capital ratio. [BCBS June 2011, par 131] This could include reducing dividend payments, share buybacks and staff bonus payments. Banks may also choose to raise new capital from the private sector as an alternative to conserving internally generated capital. The balance between these options should be discussed with supervisors as part of the capital planning process. [BCBS June 2011, par 124]

The scope of application of the Basel Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group. [BCBS June 2006, par 21]

What is the proposed approach?

Consistent with Basel III, it is proposed that the minimum risk-based capital ratio requirements for Ontario credit unions be specified for each of CET1, Total Tier 1 Capital (consisting of both CET1 and AT1), and Total Regulatory Capital (consisting of CET, AT1 and T2) classes of capital, as well as a capital conservation buffer as illustrated in the table below (discussed below). The proposed risk-based capital ratio requirements would be subject to a transition period which is described in Section 9 of this paper.

Minimum Risk-Weighted Capital (as a % of risk-weighted assets) – after transition period
  Core Equity Tier 1 (CET1) Total Tier 1 Capital (CET1 + AT1) Total Regulatory Capital (CET1 + AT1 + T2)
Minimum ratio 4.5% 6.0% 8.0%
Capital conservation buffer 0% 2.5% 2.5%
Minimum plus capital conservation buffer 4.5% 8.5% 10.5%

Furthermore, it is proposed that these minimum requirements be applied to credit unions on a consolidated basis as stated in Basel III. Therefore, the asset base to which the minimum requirements would be applied would include the assets of most types of subsidiaries, which would be risk-weighted based on the credit risk of the counterparty. This would render the current requirement in the Capital Adequacy Guideline for Ontario’s Credit Unions and Caisses Populaires to report investments in subsidiaries on an equity basis unnecessary.

Capital Conservation Buffer and Distribution Constraints

It is proposed that Ontario adopt a capital conservation buffer that applies to credit union Total Tier 1 Capital rather than CET1 capital. This adjustment is being proposed with the understanding that credit unions only issue investment and membership shares to their members, which reduces their ability to raise CET1 capital compared to other companies that can issue common shares to the public. Consideration will be given to applying the capital conservation buffer to CET1 capital in the future, once credit unions begin to meet phase-in Basel III requirements.

It is proposed that credit unions be restricted from making distributions when they do not meet minimum capital conservation requirements throughout the transition period and afterwards. The table below shows an example of restrictions on distributions that would be imposed on a credit union in year 10 when it falls below the minimum capital required at various levels of Total Tier 1 capital:

Individual credit union minimum capital conservation requirements Year 10
Column A Total Tier 1 Capital (CET1 + AT1) Ratio Column B % of Distributable Earnings
< 6.5% 0%
>6.5% - 7.0% 20%
>7.0% - 7.5% 40%
>7.5% - 8.0% 60%
>8.0% - 8.5% 80%
>8.5% 100%

[Based on table in BCBS June 2011, par 131]

The table above is based on the Basel III table “Individual bank minimum capital conservation standards” (reproduced in Appendix A), but deviates from that table in the following ways:

  • The minimum Total Tier 1 capital ratio in Column A is higher than what is required under Basel III.  This is proposed as the buffer would be applied to Total Tier 1 capital, rather than CET1 capital
  • The title of Column B has been modified from the title in the Basel III table “Minimum Capital Conservation Ratios” for clarity
  • A capital conversion requirement for 80% of distributable earnings has been added to give more flexibility to credit unions that fall into this range, whereas Basel III does not include a requirement for that level of capital

In accordance with the table, a credit union with Total Tier 1 capital (CET1 + AT1) in a range set out in Column A, would not be able to distribute more than the corresponding percentage of distributable earnings set out in Column B, in the subsequent financial year. Such distributions could include dividends, share buybacks, discretionary bonus payments, and share payments that deplete Total Tier 1 capital.

Furthermore, a credit union would not be able to make distributions on instruments included in regulatory capital when its retained earning position is negative, or where such distributions would result in retained earnings becoming negative. The credit union must retain all earnings until it returns to a positive retained earnings position (refer to Criteria 5 in Appendix B and Criteria 8 in Appendix C).

If the credit union wishes to make payments in excess of the constraints imposed, it would have the option of raising capital equal to the amount above the constraint that it wishes to distribute, subject to the prudential regulator’s approval [based on BCBS June 2011 par 124, 131].

Consistent with Basel III, it is proposed that credit unions that are aware of events that may deplete their capital conservation buffers be required to prepare capital conservation plans and submit such plans to the prudential regulator, unless the regulator authorizes otherwise.  Additional Basel III capital conservation buffer requirements are detailed in Appendix A.

It is proposed that the Basel III countercyclical buffer requirements not be considered until credit unions have started to phase in the new proposed minimum capital requirements discussed in this paper.

6.2 Leverage ratio

What is the current Ontario requirement?

Class 1 credit unions must maintain a leverage ratio of at least 5%, while Class 2 credit unions must maintain a leverage ratio of a least 4%. Effective January 1, 2018, this distinction will be eliminated and all credit unions will be subject to the same leverage ratio requirement of 4%.

What is the Basel III standard?

The Basel III leverage ratio framework is set out in the document Basel III leverage ratio framework and disclosure requirements (January 2014). The ratio is defined as Tier 1 capital divided by the exposure measure, which includes on-balance and off-balance sheet items, derivative exposures, and securities financing transaction exposures.

The minimum leverage ratio requirement is 3%. [BCBS January 2014, par 6, 7, 10, 12, 14]

What is the proposed approach?

The government has announced its intention to support the recommendations in the 2015 Report to maintain the minimum leverage ratio at 4% and to include off balance-sheet assets in the exposure measure.

Off-balance sheet assets include commitments (including liquidity facilities) whether or not unconditionally cancellable, direct credit substitutes, acceptances, standby letters of credit and trade letters of credit. However, off-balance sheet assets exclude mortgages that have been pooled and sold under the National Housing Act Mortgage Backed Securities (NHA MBS) Program and derecognized under IFRS.

Further to the recommendation made in the 2015 Report, it is proposed that the following changes be made to the methodology by which the leverage ratio is determined in order to more closely align Ontario’s framework with Basel III:

  • Only Tier 1 Capital would be considered in the leverage ratio, as opposed to Total Regulatory Capital (Tier 1 and Tier 2), as currently permitted under section 15 of the General Regulation
  • Derivatives and securities financing transaction exposures would be included in the exposure measure. Securities financing transaction exposures include items such as repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on market valuations and the transactions are often subject to margin agreements

7 Regulatory Adjustments

This section describes the key proposed changes to the regulatory adjustments under the CUCPA to more closely align with regulatory adjustments required under Basel III.

As explained earlier in Section 6.1, it is proposed that these regulatory adjustments would apply to credit unions on a consolidated basis, which would include the assets of most types of subsidiaries.

7.1 Intangible assets – CET1 deduction

What is the current Ontario requirement?

Section 16 of the General Regulation specifies that the portion of intangible assets (other than goodwill) that is greater than 5% of Tier 1 capital must be deducted from total assets of the credit union. The amount that is deducted is risk-weighted at 0%, while the amount that is not deducted is risk-weighted at 100% for the purposes of calculating the risk-based capital ratio and the leverage ratio. Some examples of intangible assets include mortgage servicing rights, core deposit intangible assets, computer software and banking systems.

What is the Basel III standard?

Goodwill and all other intangibles must be deducted in the calculation of CET1… With the exception of mortgage servicing rights, the full amount is to be deducted net of any associated deferred tax liability which would be extinguished if the intangible assets become impaired or derecognized under the relevant accounting standards. The amount to be deducted in respect of mortgage servicing rights is set out in the threshold deductions section (see Section 7.7 for details). [BCBS June 2011 par 67, 87-89]

What is the proposed approach?

It is proposed that, consistent with Basel III, all intangible assets be deducted from CET1 capital. Goodwill will continue to be fully deducted as per the current requirements. These amount that are deducted would be risk-weighted at 0%. Mortgage servicing rights would be subject to a threshold deduction described in Section 7.7.

7.2 Deferred tax assets

What is the current Ontario requirement?

Under section 18 of the General Regulation, deferred tax assets (DTAs) are risk-weighted at 100%.

What is the Basel III standard?

DTAs that rely on future profitability of the bank to be realized are to be deducted in the calculation of CET1...

Where these DTAs relate to temporary differences (e.g. allowance for credit losses) the amount to be deducted is set out in the “threshold deductions” section (see Section 7.7 for details). [BCBS 2006 par 69, 87, 89]

What is the proposed approach?

In order to align with Basel III, it is proposed that different treatments be prescribed to different types of DTAs, as follows:

  • A full CET1 deduction would be required for DTAs that relate to permanent differences (e.g., those relating to operating losses, such as the carry forward of unused tax losses, or unused tax credits)
  • A threshold deduction would be required for DTAs that relate to temporary differences relying on future profitability of the credit union (e.g., allowance for credit losses), as described in Section 7.7
  • DTAs arising from temporary differences that the credit union could realize through loss carry-backs would be 100% risk-weighted, which is consistent with the current  requirement

7.3 Deferred gain on sale of securitization transactions

What is the current Ontario requirement?

Under section 18 of the General Regulation, equity capital resulting from securitization transactions (e.g., capitalized future margin income, deferred gains on sale) are risk-weighted at 100%.

What is the Basel III standard?

In the calculation of CET1, derecognise any increase in equity capital resulting from a securitisation transaction, such as that associated with expected future margin income (FMI) resulting in a gain-on-sale. [BCBS June 2011 par 74]

What is the proposed approach?

It is proposed that deferred gains related to securitization transactions be deducted from CET1.

7.4 Investments in own shares

What is the current Ontario requirement?

Sections 61 and 64 of the CUCPA allow credit unions to hold their own shares through the realization of security in various circumstances, such as when member’s account is liquidated.

What is the Basel III standard?

All of a bank’s investments in its own common shares, whether held directly or indirectly, will be deducted in the calculation of CET1 (unless already derecognised under the relevant accounting standards). In addition, any own shares which the bank could be contractually obliged to purchase should be deducted in the calculation of CET1. [BCBS June 2011 par 78]

What is the proposed approach?

It is proposed that any shares in a credit union owned by that credit union be excluded from CET1 capital.

7.5 Reciprocal cross-holdings of shares

What is the current Ontario requirement?

Credit unions are not permitted to invest in other credit unions without approval from the prudential regulator under section 201.1 of the Act. In addition, there is currently no deduction of share cross-holdings between credit unions under the CUCPA.

What is the Basel III standard?

Reciprocal cross holdings of capital that are designed to artificially inflate the capital position of banks will be deducted in full. Banks must apply a “corresponding deduction approach” to such investments in the capital of other banks, other financial institutions and insurance entities. This means the deduction should be applied to the same component of capital for which the capital would qualify if it was issued by the bank itself. [BCBS June 2011 par 67]

What is the proposed approach?

There is no evidence that credit unions are currently cross-holding capital with other financial institutions, but as a best practice it is proposed that this Basel III principle be adopted. As a result, any reciprocal cross-holdings of capital between credit unions and financial institutions would be deducted from the same component of capital.

7.6 Investments in the capital of unconsolidated banking, financial and insurance entities

What is the current Ontario requirement?

Credit unions must report significant investments in financial institutions that are not subsidiaries using the equity method of accounting, as required by the Capital Adequacy Guideline for Ontario’s Credit Unions and Caisses Populaires. Paragraph 8 of subsection 18(2) of the General Regulation specifies that such investments are risk-weighted at 0%. Non-significant investments in financial institutions are risk-weighted according to the credit risk of the counterparty.

What is the Basel III standard?

Basel III prescribes different treatment to investments in unconsolidated entities based on degree of control over the entity.

Non-significant investments in unconsolidated banking, financial and insurance entities (10% or less)

The regulatory adjustment described in this section applies to investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation and where the bank does not own more than 10% of the issued common share capital of the entity… [BCBS June 2011 par 80]. Examples of the types of activities that financial entities might be involved in include financial leasing, issuing credit cards, portfolio management, investment advisory, custodial and safekeeping services and other similar activities that are ancillary to the business of banking. [BCBS FAQs #7 p.10]

If the total of all holdings listed above in aggregate exceed 10% of the bank’s common equity (after applying all other regulatory adjustments in full listed prior to this one) then the amount above 10% is required to be deducted, applying a corresponding deduction approach. This means the deduction should be applied to the same component of capital for which the capital would qualify if it was issued by the bank itself[BCBS June 2011 par 81]

Amounts below the threshold, which are not deducted, will continue to be risk-weighted. Thus, instruments in the… banking book should be treated as per …the standardised approach. For the application of risk-weighting the amount of the holdings must be allocated on a pro rata basis between those below and those above the threshold. [BCBS June 2011 par 83]

Significant investments in unconsolidated banking, financial and insurance entities (over 10%)

The regulatory adjustment described in this section applies to investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation where the bank owns more than 10% of the issued common share capital of the issuing entity or where the entity is an affiliate of the bank… [BCBS June 2011 par 84]

All investments included above that are not common shares must be fully deducted following a corresponding deduction approach. This means the deduction should be applied to the same tier of capital for which the capital would qualify if it was issued by the bank itself…[BCBS June 2011 par 85]

Investments included above that are common shares will be subject to the threshold treatment described in Section 7.7. [BCBS June 2011 par 86]

What is the proposed approach?

It is proposed that the Basel III approach for non-significant and significant investments be adopted, including the 10% threshold for defining whether an investment is significant for regulatory capital purposes. It is proposed that these investment rules exclude investments in centrals and leagues, which is necessary as many credit unions hold significant deposits in their centrals or leagues.

7.7 Threshold deductions

What is the current Ontario requirement?

There is currently a threshold deduction for intangible assets with balances exceeding 5% of Tier 1 capital of a credit union, which is set out in subsection 16(1) of the General Regulation.

What is the Basel III standard?

Instead of a full deduction, the following items may each receive limited recognition when calculating CET1, with recognition capped at 10% of the bank’s common equity (after the application of all regulatory adjustments):

  • Significant investments in the common shares of unconsolidated financial institutions (banks, insurance and other financial entities)
  • Mortgage servicing rights
  • DTAs that arise from temporary differences…[BCBS June 2011 par 87]

The remaining 90% of each of the three items that are not deducted in the calculation of CET1 will be risk-weighted at 250%. [BCBS June 2011 par 89]

What is the proposed approach?

As discussed in Section 7.1, 7.2and 7.6, it is proposed that a threshold deduction be adopted for mortgage servicing rights, deferred tax assets arising from temporary differences that rely on future profitability, and significant investments in financial institutions. As a result, the balance of each type of asset with a value above 10% of a credit union’s CET1 capital would be deducted from CET1 capital, and the amount not deducted would be risk-weighted at 250%.

8 Credit Risk Categories

In 2006, Basel II introduced enhanced risk-weighting requirements for assets held by a financial institution to account for the credit risk of various assets. The credit risk methodology remains largely unchanged since Basel II, except for targeted enhancements to counterparty credit risk and reliance on external credit rating agencies introduced in Basel III.

Currently, section 18 of the General Regulation sets out the credit risk-weightings for different types of assets held by a credit union, and is partially aligned with Basel II credit risk requirements. The proposed changes discussed in this section would more closely align credit union credit risk weights to the Basel II and Basel III standards.

As proposed in Section 6.1, these credit risk requirements would apply to credit unions on a consolidated basis, which would include the assets of most types of subsidiaries.

The term “claims” used below refers to assets on a credit union’s financial statements that represent an investment in, or loan to, a third party.

8.1 Claims on sovereigns and public service entities

What is the current Ontario requirement?

Claims against or guaranteed by a Canadian government or agency are risk-weighted at 0%. Similar claims against foreign governments are weighted at 100%. Public service entities (PSEs) which include Canadian municipalities, school boards, colleges, hospitals, universities and social service providers that receive regular government financial support, are subject to a risk-weighting of 20%.

What is the Basel II standard?

Claims on sovereigns and their central banks will be risk-weighted as follows:


Credit Assessment (S&P)
AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated
Risk-Weight 0% 20% 50% 100% 150% 100%

[BCBS June 2006 par 53]

At national discretion, a lower risk-weight may be applied to banks’ exsposures to their sovereign (or central bank) of incorporation denominated in domestic currency and funded in that currency. [BCBS June 2006 par 54]

Claims on domestic PSEs will be risk-weighted at national discretion, according to claims on banks. Subject to national discretion, claims on certain domestic PSEs may also be treated as claims on the sovereigns in whose jurisdictions the PSEs are established. [BCBS June 2006 par 57, 58]

What is the proposed approach?

Consistent with Basel II, it is proposed that claims against or guaranteed by a Canadian government or agency continue to be risk-weighted at 0%. It is proposed that claims on foreign sovereign entities be weighted according to the credit risk of the country based on the table above using S&P ratings, or equivalent credit ratings from DBRS, Moody’s Investors Service, or Fitch Rating Services.

Furthermore, it is proposed that claims on PSEs receive a risk-weight that is one category higher than the sovereign risk-weight as per the table below. As a result, claims on PSEs in foreign jurisdictions would be weighted one category higher than their sovereign. Claims on PSEs in Canadian jurisdictions would continue to receive a risk-weight of 20%, in line with current requirements.

Credit Assessment of sovereign AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated
Sovereign Risk Weight 0% 20% 50% 100% 150% 100%
PSE Risk Weight 20% 50% 100% 100% 150% 100%

8.2 Claims on corporate entities

What is the current Ontario requirement?

The current Capital Adequacy Guideline for Ontario’s Credit Unions and Caisses Populaires requires loans to commercial entities to be risk-weighted according to the credit rating of the entity. All other claims on corporates, such as investment in shares or bonds, are risk-weighted at 100%.

What is the Basel II standard?

The table below illustrates the risk-weighting of rated corporate claims, including claims on insurance companies. The standard risk weight for unrated claims on corporates will be 100%. No claim on an unrated corporate may be given a risk weight preferential to that assigned to its sovereign of incorporation.

Credit assessment
(S&P)
AAA to AA- A+ to A- BBB+ to BB- Below BB- Unrated
Risk Weight 20% 50% 100% 150% 100%

[BCBS June 2006 par 66]

Commercial undertakings owned by central governments, regional governments or by local authorities may be treated as normal commercial enterprises. However, if these entities function as a corporate in competitive markets even though the state, a regional authority or a local authority is the major shareholder of these entities, supervisors should decide to consider them as corporates and therefore attach to them the applicable risk weights. [BCBS June 2006 par 58, footnote 23]

What is the proposed approach?

It is proposed that all claims on commercial entities be weighted in accordance with the table above, based on the credit rating of the corporate entity. As a clarification, claims on corporations that are not financial institutions, but that own deposit-taking institutions, would be treated as corporate exposures. Furthermore, certain PSEs that are in significant competition with the private sector would be weighted in accordance with the table above. The prudential regulator would make a determination as to whether the corporate risk-weighting should apply to specific PSEs.

8.3 Claims on deposit-taking institutions and banks

What is the current Ontario requirement?

The General Regulation specifies a risk-weighting of 20% for claims on a bank or authorized foreign bank within the meaning of section 2 of the Bank Act (Canada), a corporation registered under the Loan and Trust Corporations Act or a corporation to which the Trust and Loan Companies Act (Canada) or similar legislation of another province or territory of Canada applies. Such claims include deposits, commercial paper, bankers’ acceptances, bankers’ demand notes and similar guaranteed instruments. Any similar claims in foreign deposit-taking institutions are risk-weighted at 100%.

What is the Basel II standard?

All banks incorporated in a given country will be assigned a risk weight one category less favourable than that assigned to claims on the sovereign of that country. However, for claims on banks in countries with sovereigns rated BB+ to B- and on banks in unrated countries the risk-weight will be capped at 100%.

Credit assessment of Sovereign AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated
Risk-weight 20% 50% 100% 100% 150% 100%

[BCBS June 2006 par 63]

What is the proposed approach?

Consistent with Basel II, it is proposed that the table above be adopted for claims on deposit-taking institutions, whereby claims would be weighted according to the rating given to the counterparty by a major credit rating agency. As a result, the risk-weighting applied to a claim on a deposit-taking institution would be dependent on the credit assessment of the sovereign in which the institution is incorporated. The deposit-taking institution’s risk-weight would be one level less favourable than that which applies to its sovereign of incorporation. As a result, the existing 20% risk-weighting for claims on domestic deposit-taking institutions would be maintained while claims on foreign deposit-taking institutions may change from the existing risk-weight of 100%.

8.4 1250% risk-weight for certain assets

What is the current Ontario requirement?

Currently, no assets held by credit unions are subject to a 1250% risk-weighting under the CUCPA.

What is the Basel III standard?

The following items… will receive a 1250% risk weight:

  1. Certain securitization exposures...
  2. Significant investments in commercial entities [BCBS June 2011 par 90]

What is the proposed approach?

Securitization exposures

It is proposed that certain securitization transactions be risk-weighted at 1250%. Such transactions could include the provision of credit risk mitigants to a securitization transaction, investments in asset-backed securities, retention of a subordinated tranche, extension of a liquidity facility or credit enhancement, and purchase of credit-enhancing interest-rate overnight swaps. While little evidence of such activity exists in Ontario’s credit union sector, it is proposed that this Basel III requirement be adopted as a best practice for potential activity in these sorts of securitization transactions. This would not include traditional mortgage securitization activity in which credit unions currently participate, where mortgage loan receivables are sold through the NHA MBS Program or other similar vehicles which are currently weighted at 0%.  

Commercial entities

Commercial entities are non-financial and non-securities entities that are involved in activities such as financial leasing, issuing credit cards, portfolio management, investment advisory, custodial and safekeeping services and other similar activities that are ancillary to the business of deposit-taking institutions. The term “significant investment” refers to an investment into another entity that represents more than 10% of the issued common share capital of that entity, as described under Section 7.6.

Recognizing that credit unions can have significant investments in commercial entities through joint ventures and partnerships with community organizations and small businesses, we are seeking input, through this consultation, on whether investments in certain types of commercial entities should be excluded from a 1250% risk-weighting.

9 Transitional Arrangements

This section details the proposed phase-in of the minimum risk-based capital ratio requirements detailed in Section 6. They are predicated on the assumption that the Legislative Assembly enact a new CUCPA, and the approval of regulations and other instruments under that new Act which implements the capital adequacy framework proposals described in this paper.  

It is proposed that the risk-based capital ratio requirements be phased in over 10 years, with incremental increases in two phases:

Phase 1 (Years 1-5): In the first 5 years of transition, all existing Tier 1 capital instruments (investment shares, patronage shares and membership shares) would continue to be classified as Tier 1 capital. The table below shows the minimum proposed requirements in the beginning (Year 1) and end (Year 5) of Phase 1. Minimum capital requirements for Tier 1 and Tier 2 capital will be increased incrementally between Year 1 and Year 5, and credit unions would be expected to meet or exceed these minimums. During this period, credit unions will have the option of gradually changing the terms and conditions of existing shares, or issuing new shares, in a manner that would enable them to meet minimum requirements. Credit unions would report sub-categories of Tier 1 capital (CET1, AT1) to the prudential regulator to track progress to transition at Phase 2.

Phase 2 (Years 6-10): Starting in the 6th year of transition, all existing and new instruments would be classified in the appropriate Basel III category (CET1, AT1, T2) based on the criteria for each category (in accordance with Section 4). Minimum requirements for each category of capital would continue to be increased incrementally until the minimum Basel III ratios described in Section 6 are reached in Year 10 (also detailed in the table below). Credit unions would be expected to meet or exceed minimum capital requirements throughout Phase 2.

Component of capital Minimum Risk-based Capital Ratio - Year 1 Minimum Risk-based Capital Ratio - Year 5 Minimum Risk-based Capital Ratio - Year 10
Core Equity Tier 1 capital (CET1) - - 4.50%
Additional Tier 1 capital (AT1) - - 1.50%
Total Tier 1 capital (T1) 4.50% 5.50% 6.00%
Capital conservation buffer 0.00% 1.00% 2.50%
Total Tier 1 + buffer 4.50% 6.50% 8.50%
Tier 2 capital (T2) 3.50% 2.50% 2.00%
Total Capital 8.00% 9.00% 10.50%

Detailed transitional provisions and guidance will be provided in the future.

The capital conservation buffer would also be phased in incrementally over this transition period, with capital distributions imposed on credit unions each year similar to those described in Section 6.1.

It is anticipated that any new credit union would apply to the prudential regulator for a variance from meeting regulatory capital requirements in their start-up phase to allow them to accumulate the required capital.

10  Consultation Questions

  1. Do you have any general feedback concerning the proposed capital adequacy framework for Ontario credit unions described in this paper?
  2. Do you believe that the modifications to the Basel III framework proposed in this paper would result in a framework that is suitable for Ontario credit unions? Are there any modifications proposed in this paper that you disagree with? What additional modifications to the Basel III framework, if any, should be considered to reflect the unique capital structure of Ontario credit unions?
  3. OSFI has implemented detailed requirements in its capital adequacy framework that are not set out in Basel III documentation, such as those applying to reverse mortgages and pass-through type mortgage backed securities. Should Ontario consider adopting these and/or other measures not specifically set out in Basel III and not discussed in this paper?
  4. Is a 1250% risk-weight of significant investments in commercial entities under the CUCPA appropriate (see Section 8.4 above)? Should significant investments in certain types of commercial entities be excluded from the application of a 1250% risk-weighting? If yes, please describe the types of commercial entities that should be excluded, the risk-weightings that you believe would be appropriate for such entities and your rationale for both the exclusion and risk-weighting. 

Glossary

Additional Tier 1 capital (AT1)

A subcategory of Tier 1 capital, with the characteristics described in Section 4.1.2. Capital instruments included in this category of capital must generally be issued and paid-in, subordinated to depositors, general creditors and subordinated debt of the credit union, and perpetual in nature.

Affiliate

A company that controls, is controlled by, or is under common control by another party.

Capital conservation buffer

2.5% of capital that must be held in addition to the CET1 minimum risk-based capital ratio. Institutions that hold less than 2.5% in capital conservation buffer must reduce their distributions appropriately. See Section 6.1 for further details.

Claim to residual Assets

A condition of capital where shareholders are entitled to receive the remaining assets of a dissolved institution after the claims of all creditors and priority shareholders have been satisfied.

Class 1 credit union

A credit union whose total assets, as set out in the audited financial statements of the credit union that were placed before its members at the most recent annual meeting, are less than $50 million, or if the credit union does not have any commercial loans. On January 1, 2018, class distinctions will be removed and class 1 credit unions will be subject to class 2 rules.

Class 2 credit union

A credit union whose total assets, as set out in the audited financial statements of the credit union that were placed before its members at the most recent annual meeting, are greater than or equal to $50 million, or if the credit union makes one or more commercial loans.

Core Equity Tier 1 (CET1)

The highest quality of Tier 1 capital, which is further detailed in Section 4.1.1. CET1 capital typically has qualities of permanence, loss absorbency, subordination and a claim on residual assets of the entity.   

Consolidated basis

Refers to the use of consolidated financial statements in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity.

Countercyclical buffer

A Basel III buffer requirement that is deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure that the banking system has excess capital to protect it against future potential losses. The buffer can be between zero and 2.5% of risk-weighted assets on top on minimum capital requirements and the capital conservation buffer requirements.

Credit risk

The risk that a counterparty to a transaction could default before the final settlement of the transaction's cash flows.

Cross-holding of capital

An arrangement whereby two entities enter into a transaction to purchase capital of one another.

Deposit-taking institution

A financial institution whose primary business involves receiving deposits or close substitutes for deposits and granting credits to third parties. Examples include banks, loan and trust corporations and credit unions.

Distributions

A company's payment to its shareholders and members out of distributable items such as retained earnings, which could include dividends, share buybacks, discretionary bonus payments, and share payments.

Interest rate risk

The risk that changes in market interest rates might adversely affect an institution's financial condition.

Joint stock companies

Companies that have issued common shares, irrespective of whether these shares are held privately or publicly. These represent the vast majority of internationally active banks.

Leverage ratio

The leverage ratio is generally calculated by dividing regulatory capital by total assets of the institution (See Section 6.2 for definition of components):

Regulatory Capital
Assets and other exposures

Loss-absorbency

A characteristic of capital whereby the holder of the capital instrument absorbs losses incurred by an institution before any other creditors or priority shareholders.

Market risk

Market risk is defined as the risk of losses in on- or off-balance sheet positions that arise from movement in market prices. This includes: (1) Risks pertaining to interest rate related instruments and equities in the trading book; (2) Foreign exchange risk and commodities risk throughout the institution.

Mortgage servicing rights

An intangible asset representing a contractual agreement where the right to service an existing mortgage is sold by the original lender to another party who specializes in servicing mortgages.

Non-consolidated financial statements

Financial statements where investments in subsidiaries are recorded using the equity method of accounting as described in the Capital Adequacy Guideline for Ontario’s Credit Unions and Caisses Populaires.

Operational risk

The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Permanence

A quality of capital where shareholders do not have any expectation that the issuing institution will redeem their shares in the future.

Resolution tools

Tools of the regulatory authority that may be used when an institution’s recovery framework is insufficient to mitigate stress faced by it. Examples of resolution actions could include recapitalization, restructuring and winding down the financial institution.

Risk-based capital ratio

The risk-based capital ratio is calculated by dividing regulatory capital by total risk-weighted assets, a market risk charge and an operational risk charge (see Section 6.1 for details on components). The ratio is expressed as a percentage:

Regulatory Capital Assets and other exposures
RiskWeighted Assets + Market Risk Charge + Operational Risk Charge

Subordinated indebtedness

Lower priority debt compared to other debt held by a financial institution. For example, a debt owed to an unsecured creditor that can only be paid in the event of a liquidation after the claims of secured creditors have been met.

Tier 1 (T1) capital

A category of capital consisting of AT1 and CET1 capital. See Section 4.1for detailed definition.

Tier 2 (T2) capital

A category of capital that is of lesser quality compared to Tier 1 capital. See Section 4.2 for detailed definition.  

Appendix A: Capital Conservation Buffer

This appendix contains excerpts of paragraphs 129-132 of the Basel III standard detailing capital conservation buffer requirements.

A capital conservation buffer of 2.5%, comprised of CET1, is established above the regulatory minimum capital requirement. Capital distribution constraints will be imposed on a bank when capital levels fall within this range. Banks will be able to conduct business as normal when their capital levels fall into the conservation range as they experience losses. The constraints imposed only relate to distributions, not the operation of the bank. [BCBS 2011, par 129]

The distribution constraints imposed on banks when their capital levels fall into the range increase as the banks’ capital levels approach the minimum requirements. By design, the constraints imposed on banks with capital levels at the top of the range would be minimal. This reflects an expectation that banks’ capital levels will from time to time fall into this range. The Basel Committee does not wish to impose constraints for entering the range that would be so restrictive as to result in the range being viewed as establishing a new minimum capital requirement.  [BCBS 2011, par 130]

The table below shows the minimum capital conservation ratios a bank must meet at various levels of the CET1 capital ratios…[BCBS 2011, par 131]

Individual bank minimum capital conservation standards
CET1 Ratio Minimum Capital Conservation Ratios
(Expressed as a percentage of earnings)
4.5% - 5.125% 100%
>5.125% - 5.75% 80%
>5.75% - 6.375% 60%
>6.375% - 7.0% 40%
> 7.0% 0%

Set out below are a number of other key aspects of the requirements:

  1. Elements subject to the restriction on distributions: Items considered to be distributions include dividends and share buybacks, discretionary payments on other Tier 1 capital instruments and discretionary bonus payments to staff. Payments that do not result in a depletion of CET1, which may for example include certain strip dividends, are not considered distributions.
  2. Definition of earnings: Earnings are defined as distributable profits calculated prior to the deduction of elements subject to the restriction on distributions. Earnings are calculated after the tax which would have been reported had none of the distributable items been paid. As such, any tax impact of making such distributions are reversed out. Where a bank does not have positive earnings and has a CET1 ratio less than 7%, it would be restricted from making positive net distributions.
  3. Solo or consolidated application: The framework should be applied at the consolidated level, i.e. restrictions would be imposed on distributions out of the consolidated group. National supervisors would have the option of applying the regime at the solo level to conserve resources in specific parts of the group.
  4. Additional supervisory discretion: Although the buffer must be capable of being drawn down, banks should not choose in normal times to operate in the buffer range simply to compete with other banks and win market share. To ensure that this does not happen, supervisors have the additional discretion to impose time limits on banks operating within the buffer range on a case-by-case basis. In any case, supervisors should ensure that the capital plans of banks seek to rebuild buffers over an appropriate timeframe. [BCBS 2011, par 132]

Appendix B: CET1 - Basel III Criteria for Inclusion in CET1 Capital

This appendix contains excerpts of paragraph 53 of the Basel III standard.

For an instrument to be included in CET1 capital, it must meet all of the following criteria:

  1. Represents the most subordinated claim in liquidation of the bank.
  2. Entitled to a claim on the residual assets that is proportional with its share of issued capital, after all senior claims have been repaid in liquidation (i.e. has an unlimited and variable claim, not a fixed or capped claim).
  3. Principal is perpetual and never repaid outside of liquidation (setting aside discretionary repurchases or other means of effectively reducing capital in a discretionary manner that is allowable under relevant law).
  4. The bank does nothing to create an expectation at issuance that the instrument will be bought back, redeemed or cancelled nor do the statutory or contractual terms provide any feature which might give rise to such an expectation.
  5. Distributions are paid out of distributable items (retained earnings included). The level of distributions is not in any way tied or linked to the amount paid in at issuance and is not subject to a contractual cap (except to the extent that a bank is unable to pay distributions that exceed the level of distributable items).
  6. There are no circumstances under which the distributions are obligatory. Non-payment is therefore not an event of default.
  7. Distributions are paid only after all legal and contractual obligations have been met and payments on more senior capital instruments have been made. This means that there are no preferential distributions, including in respect of other elements classified as the highest quality issued capital.
  8. It is the issued capital that takes the first and proportionately greatest share of any losses as they occur. Within the highest quality capital, each instrument absorbs losses on a going concern basis proportionately and pari passu with all the others.
  9. The paid-in amount is recognised as equity capital (i.e. not recognised as a liability) for determining balance sheet insolvency.
  10. The paid-in amount is classified as equity under the relevant accounting standards.
  11. It is directly issued and paid-in (Note 1) and the bank cannot directly or indirectly have funded the purchase of the instrument.
  12. The paid-in amount is neither secured nor covered by a guarantee of the issuer or related entity (Note 2) or subject to any other arrangement that legally or economically enhances the seniority of the claim.
  13. It is only issued with the approval of the owners of the issuing bank, either given directly by the owners or, if permitted by applicable law, given by the Board of Directors or by other persons duly authorised by the owners.
  14. It is clearly and separately disclosed on the bank’s balance sheet. [BCBS June 2011 par 53]

Note 1: Paid-in capital generally refers to capital that has been received with finality by the institution, is reliably valued, fully under the institution’s control and does not directly or indirectly expose the institution to the credit risk of the investor. [BCBS FAQ #5]

Note 2: A related entity can include a parent company, a sister company, a subsidiary or any other affiliate. A holding company is a related entity irrespective of whether it forms part of the consolidated banking group.

Appendix C: AT1 - Basel III Criteria for Inclusion in AT1 capital

This appendix contains excerpts of paragraph 55 of the Basel III standard.

For an instrument to be included in AT1 capital, it must meet all of the following criteria:

  1. Issued and paid-in.
  2. Subordinated to depositors, general creditors and subordinated debt of the bank.
  3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors.
  4. Is perpetual, i.e. there is no maturity date and there are no step-ups or other incentives to redeem.
  5. May be callable at the initiative of the issuer only after a minimum of five years:
    1. To exercise a call option a bank must receive prior supervisory approval; and
    2. A bank must not do anything which creates an expectation that the call will be exercised; and
    3. Banks must not exercise a call unless:
      • They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank (Note 1); or
      • The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised (Note 2).
  6. Any repayment of principal (e.g. through repurchase or redemption) must be with prior supervisory approval and banks should not assume or create market expectations that supervisory approval will be given.
  7. Dividend/coupon discretion:
    1. the bank must have full discretion at all times to cancel distributions/payments (Note 3)
    2. cancellation of discretionary payments must not be an event of default
    3. banks must have full access to cancelled payments to meet obligations as they fall due
    4. cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders.
  8. Dividends/coupons must be paid out of distributable items.
  9. The instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organisation’s credit standing.
  10. The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law.
  11. Instruments classified as liabilities for accounting purposes must have principal loss absorption through either (i) conversion to common shares at an objective pre-specified trigger point or (ii) a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point. The write-down will have the following effects:
    1. Reduce the claim of the instrument in liquidation;
    2. Reduce the amount re-paid when a call is exercised; and
    3. Partially or fully reduce coupon/dividend payments on the instrument.
  12. Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument.
  13. The instrument cannot have any features that hinder recapitalisation, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame.
  14. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g. a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity (Note 4) or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Additional Tier 1 capital. [BCBS June 2011 par 55]

Note 1: Replacement issues can be concurrent with but not after the instrument is called.

Note 2: Minimum refers to the regulator’s prescribed minimum requirement, which may be higher than the Basel III Pillar 1 minimum requirement.

Note 3: A consequence of full discretion at all times to cancel distributions/payments is that “dividend pushers” are prohibited. An instrument with a dividend pusher obliges the issuing bank to make a dividend/coupon payment on the instrument if it has made a payment on another (typically more junior) capital instrument or share. This obligation is inconsistent with the requirement for full discretion at all times. Furthermore, the term “cancel distributions/payments” means extinguish these payments. It does not permit features that require the bank to make distributions/payments in kind.

Note 4: An operating entity is an entity set up to conduct business with clients with the intention of earning a profit in its own right.

Appendix D: T2 - Basel III Criteria for Inclusion in T2 CapitaL

This appendix contains excerpts of paragraph 58 of the Basel III standard.

For an instrument to be included in T2 capital it must meet all of the following criteria:

  1. Issued and paid-in.
  2. Subordinated to depositors and general creditors of the bank.
  3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis depositors and general bank creditors.
  4. Maturity:
    1. minimum original maturity of at least five years
    2. recognition in regulatory capital in the remaining five years before maturity will be amortised on a straight line basis
    3. there are no step-ups or other incentives to redeem
  5. May be callable at the initiative of the issuer only after a minimum of five years:
    1. To exercise a call option a bank must receive prior supervisory approval;
    2. A bank must not do anything that creates an expectation that the call will be exercised (Note 1); and
    3. Banks must not exercise a call unless:
      • They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank (Note 2); or
      • The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised (Note 3).
  6. The investor must have no rights to accelerate the repayment of future scheduled payments (coupon or principal), except in bankruptcy and liquidation.
  7. The instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organisation’s credit standing.
  8. Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument.
  9. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g., a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Tier 2 Capital. [BCBS June 2011 par 58]

Note 1: An option to call the instrument after five years but prior to the start of the amortisation period will not be viewed as an incentive to redeem as long as the bank does not do anything that creates an expectation that the call will be exercised at this point.

Note 2: Replacement issues can be concurrent with but not after the instrument is called.

Note 3: Minimum refers to the regulator’s prescribed minimum requirement, which may be higher than the Basel III Pillar 1 minimum requirement.


[1] See http://www.bis.org/bcbs/publ/d408.htm

[2] See https://www.dico.com/design/5_0_Eng.html#INTERNAL-CAPITAL-ADEQUACY-ASSESSMENT-PROCESS-AND-STRESS-TESTING

[3] See http://www.dico.com/design/Publications/En/2013%20Capital%20Adequacy%20Guideline.doc

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