DBRS: Canadian Banks’ NVCC Instruments Rateable Based on OSFI Advisory

DBRS has concluded today that it expects it can rate Canadian subordinated debt with a non-viability contingent capital clause (sub debt NVCC) and Canadian preferred shares with a non-viability contingent capital clause (pref NVCC) following the review of the Office of the Superintendent of Financial Institutions Canada (OSFI) Advisory on Non-Viability Contingent Capital, issued on August 16, 2011 (NVCC Advisory).

In this document, all references to non-viability contingent capital (NVCC) instruments are based on our expectations that non-viability (as determined by OSFI) is the only contingent event, that the contingent event triggers permanent conversion to common equity and that over time, as NVCC becomes the major instrument with respect to subordinated debt and preferred shares, any trigger event for sub debt NVCC holders would cause these holders to become meaningful owners of the bank in question. These considerations are also consistent with our ability to rate the NVCC instruments. According to DBRS criteria, the triggers are well defined and permit an assessment of the risks.

Both the sub debt NVCC and pref NVCC ratings will have wider notching, based on the global standard notching for preferred shares, because of additional risk associated with tripping the trigger. The expected losses resulting from tripping the trigger would have an impact on the relative rating of sub debt NVCC and pref NVCC. As guidance, sub debt NVCC will likely be rated no higher than the standard rating for preferred shares and the pref NVCC will likely be rated one notch below the standard rating for preferred shares.

The final ratings can only be determined after assessing the terms provided in an offering document.

For clarity, global standard notching for preferred shares means the starting point for notching preferred share ratings is the intrinsic assessment (IA) rating rather than the final senior debt rating, and the degree of notching from the IA rating to the preferred share rating widens to reflect our perception of the increased risk in these capital instruments. The base notching policy is three notches for AA, four notches for “A” and five notches for BBB and lower IA ratings. Note that when DBRS initiated the criteria on June 29, 2009, most banks in Canada had their preferred share ratings downgraded to only one notch above the global standard notching for preferred shares. This reflects the strength of the banks’ capital levels, ongoing capital generation to pay preferred and common share dividends, accessibility to the capital markets at all levels of the capital structure and absence of any political or regulatory pressure to reduce preferred share dividends as the Canadian financial system remained robust. (For additional detail, see individual bank press releases issued on June 29, 2009.)

The expected rating levels for sub debt NVCC and pref NVCC reflect the application of DBRS’s existing rating methodology. DBRS’s methodology Rating Bank Subordinated Debt and Hybrid Capital Instruments with Contingent Risks is the primary source of guidance in assessing NVCC instruments. In this methodology, DBRS looks to the likelihood of tripping the trigger event and the expected losses as a result of the conversion.

DBRS has determined that the likelihood of tripping the trigger event (i.e., non-viability as determined by OSFI) would be very hard or remote. DBRS’s decision was based on the assessment of the criteria to be considered in triggering conversion of NVCC instruments that was spelled out in the NVCC advisory by OSFI. Lower-rated banks suggest an increased probability of conversion as a result of tripping the trigger given the greater need for a bank to generate regulatory capital. This would result in higher notching from the intrinsic assessment, as set out in the DBRS methodology Rating Bank Preferred Shares and Equivalent Hybrids. As such, both the sub debt NVCC and pref NVCC ratings would be tied to the preferred share rating of the bank.

The expected losses as a result of the conversion would affect the rating for sub debt NVCC relative to pref NVCC. It is the economic entitlement each receives post-trigger that is the significant factor in the relative ratings as opposed to the host security’s pre-trigger features. This economic entitlement can be assessed only after terms are provided in a contractual agreement between the issuing bank and the purchaser.

The NVCC Advisory is consistent with OSFI’s Draft Advisory issued February 4, 2011, and the release by the Basel Committee on Banking Supervision (BCBS) on minimum requirements to ensure loss absorbency at the point of non-viability (January 13, 2011). The NVCC Advisory sets out the governing principles, information requirements and criteria to be considered in triggering a conversion of NVCC.

The principal methodologies applicable are the Global Methodology for Rating Banks and Banking Organisations (January 2010), Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments (February 2009) and Rating Bank Subordinated Debt and Hybrid Capital Instruments with Contingent Risks (April 2010), which can be found on www.dbrs.com under Methodologies.